Untitled

The Appraisal
of Real Estate
Fifteenth Edition
Readers of this text may be interested in the following publications from the
Appraisal Institute:
• The Dictionary of Real Estate Appraisal
• Market Analysis for Real Estate
• Residential Property Appraisal
• Rural Property Valuation
• Scope of Work
• The Student Handbook to The Appraisal of Real Estate
The Appraisal
of Real Estate
Fifteenth Edition
Appraisal Institute • 200 W. Madison • Suite 1500 • Chicago, IL 60606 • www.appraisalinstitute.org

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The Appraisal of Real Estate, 15th edition, peer-reviewed by Appraisal Institute members is, at
the time of its publication, an authoritative source of recognized methods and techniques for
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Library of Congress Cataloging-in-Publication Data
Names: Appraisal Institute (U.S.)
Title: The appraisal of real estate / Appraisal Institute.
Description: 15th edition. | Chicago: Appraisal Institute, 2020. | Revised
edition of The appraisal of real estate, [2014] | Includes
bibliographical references and index.
Identifiers: LCCN 2019031830 | ISBN 9781935328780 (hardcover)
Subjects: LCSH: Real property--Valuation. | Personal property--Valuation.
Classification: LCC HD1387 .A663 2020 | DDC 333.33/2--dc23
LC record available at https://lccn.loc.gov/2019031830
Table of Contents
Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix
Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi
PART I Real Estate and Its Appraisal

Chapter 1 Introduction to Appraisal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Chapter 2 Land, Real Estate, and Ownership of Real Property . . . . . . . . . . . . . . . . 9
Chapter 3 The Nature of Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Chapter 4 The Valuation Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
PART II Identification of the Problem

Chapter 5 Elements of the Assignment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Chapter 6 Identifying the Type of Value and Its Definition . . . . . . . . . . . . . . . . . . 47
Chapter 7 Identifying the Rights to Be Appraised . . . . . . . . . . . . . . . . . . . . . . . . . . 59
PART III Scope of Work Determination

Chapter 8 Scope of Work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
PART IV Data Collection and Property Description
Chapter 9 Data Collection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
Chapter 10 Economic Trends in Real Estate Markets and Capital Markets . . . . . 111
Chapter 11 Neighborhoods, Districts, and Market Areas . . . . . . . . . . . . . . . . . . . . 137
Chapter 12 Land and Site Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
Chapter 13 Building Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
PART V Data Analysis

Chapter 14 Statistical Analysis in Appraisal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
Chapter 15 Market Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Chapter 16 Applications of Market Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
Chapter 17 Highest and Best Use Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
Chapter 18 The Application of Highest and Best Use Analysis . . . . . . . . . . . . . . . 317
PART VI Land Value Opinion

Chapter 19 Land and Site Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
Part VII Application of the Approaches to Value

Chapter 20 The Sales Comparison Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
Chapter 21 Comparative Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
Chapter 22 Applications of the Sales Comparison Approach . . . . . . . . . . . . . . . . .397
Chapter 23 The Income Capitalization Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . 413
Chapter 24 Income and Expense Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435
Chapter 25 Direct Capitalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459
Chapter 26 Yield Capitalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475
Chapter 27 Discounted Cash Flow Analysis and Investment Analysis . . . . . . . . 493
Chapter 28 Applications of the Income Capitalization Approach . . . . . . . . . . . . . 505
Chapter 29 The Cost Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
Chapter 30 Building Cost Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543
Chapter 31 Depreciation Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559
vi The Appraisal of Real Estate

PART VIII Reconciliation of the Value Indications and Final Opinion of Value
Chapter 32 Reconciling Value Indications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599
PART IX Report of Defined Value

Chapter 33 The Appraisal Report . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605
PART X Appraisal Practice Specialties

Chapter 34 Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627
Chapter 35 Consulting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645
Chapter 36 Valuation for Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 651
Chapter 37 Valuation of Real Property with Related Non-realty Items . . . . . . . . 663
ADDENDA
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681
Supplementary content is available online at
www.appraisalinstitute.org/15th-edition-appendices/
Appendix A Professional Practice and Law
Appendix B Regression Analysis and Statistical Applications
Appendix C Financial Formulas
Bibliography
Table of Contents vii

Foreword
In 2008, when the thirteenth edition of The Appraisal of Real Estate was published, the
global economy was on the verge of a startling decline and the ensuing economic
distress affected most economic sectors, especially real estate. The cause of that decline
was man-made, and, in retrospect, it was likely avoidable. When the fourteenth edition
of The Appraisal of Real Estate was published in 2013, real estate markets were still recov-
ering from that economic downtown. By then, many real estate professionals had taken
heed of the problem and learned that true value is based on fundamentals, not market
speculation. As the economy rebounded, the real estate community of the last decade
continued to thrive and assert itself in a stronger, more accountable environment.
We find ourselves in a situation much like 2008 today, with a global pandemic
and social justice concerns affecting all areas of the economy—and many other as-
pects of daily life—in the United States and around the world.
Today, appraisers and users of appraisal services do not know what the future
will look like. Will the changes we have made and will make to our lives and our
businesses be permanent or temporary? Will the effects of these dramatic events
change the shape of our cities and towns forever or simply force us to move forward
in new directions? Although we know that “business as usual” is no longer possible,
we do not know much more. At this juncture, the best we can do is accept the current
reality and have faith in knowing that we have the expertise to handle the challenges
that lie ahead and that they will be addressed in our usual unbiased manner and
with patience, flexibility, and a respect for market fundamentals.
This fifteenth edition of The Appraisal of Real Estate is a book that fits the times. It
reflects a renewed commitment to the essential principles of appraisal and the sound
application of recognized valuation methodology. Longtime readers of The Appraisal
of Real Estate will notice significant changes in this text. Like the previous edition, the
new book is structured to mirror the organization of the valuation process, moving
from the identification of the problem through to the report of defined value. Div-
ing deeper, the most noticeable change they will find in this edition is the expanded
discussion of market analysis and highest and best use, with new chapters clarifying
these important concepts and demonstrating procedures for their application. For the
first time, the relationship between market analysis and highest and best use is made
explicit and described in a step-by-step analytic procedure. Another major develop-
ment in this new edition is the emphasis on the necessity of definitively describing
the property rights to be appraised in an appraisal assignment to ensure that all the
necessary steps are taken to produce a credible value conclusion.
History confirms that the applicability and importance of different valuation
techniques may rise and fall as real estate markets expand and change and as society
continues to evolve. Nevertheless, the basic principles of valuation that are at the core
of this book, and fundamental to the appraiser’s skills set, remain unchanged.
Finally, The Appraisal of Real Estate, fifteenth edition, would not have been pos-
sible without the contributions of dozens of volunteers, who are identified in the
Acknowledgments. Their dedicated efforts to improve the textbook over the course
of an arduous two-year development process are a testament to the profession’s
thought leaders and their commitment to move the body of knowledge forward and
to ensure that The Appraisal of Real Estate retains its central role in professional valua-
tion literature.
Jefferson L. Sherman, MAI, AI-GRS

2020 President
Appraisal Institute
x The Appraisal of Real Estate

Acknowledgments
The development of the fifteenth edition of The Appraisal of Real Estate would not
have been possible without contributions from a long list of valuation professionals
active in advancing the Appraisal Institute’s education, publications, and other en-
deavors. The Appraisal Institute would like to acknowledge the generous assistance
of the following content reviewers and consultants: Gregory J. Accetta, MAI, AI-GRS,
Sandra K. Adomatis, SRA, Marius Andreasen, MAI, Randall Bell, PhD, MAI, Charles
T. Brigden, MAI, Stephanie C. Coleman, MAI, SRA, AI-GRS, AI-RRS, M. Lance Coyle,
MAI, SRA, Stephen T. Crosson, MAI, SRA, Douglas S. Defoor, MAI, AI-GRS, Dennis
J. Duffy, MAI, Larry O. Dybvig, Don M. Emerson, Jr., MAI, SRA, Stephen F. Fanning,
MAI, AI-GRS, Brian J. Flynn, MAI, AI-GRS, Kenneth G. Foltz, MAI, SRA, AI-GRS,
Mark R. Freitag, SRA, Daniel M. Fries, SRA, Justin R. Glasser, MAI, Craig M. Har-
rington, SRA, AI-RRS, Frank E. Harrison, MAI, SRA, Steven J. Herzog, MAI, AI-GRS,
Thomas O. Jackson, PhD, MAI, Jeffrey A. Johnson, Kerry M. Jorgensen, MAI, Paula
K. Konikoff, JD, MAI, AI-GRS, Cheryl A. Kunzler, SRA, AI-RRS, David C. Lennhoff,
MAI, SRA, AI-GRS, Mark R. Linné, MAI, SRA, AI-GRS, Micheal R. Lohmeier, MAI,
SRA, George R. Mann, MAI, SRA, AI-GRS, Richard Marchitelli, MAI, Maureen Mas-
troieni, MAI, Dan P. Mueller, MAI, James L. Murrett, MAI, SRA, Mark Ratterman,
MAI, SRA, Stephen D. Roach, MAI, SRA, AI-GRS, Scott Robinson, MAI, SRA, AI-
GRS, AI-RRS Richard J. Roddewig, MAI, Timothy P. Runde, MAI, Michael V. Sanders,
MAI, SRA, Scott M. Schafer, MAI, John A. Schwartz, MAI, Benjamin R. Sellers, MAI,
Leslie P. Sellers, MAI, SRA, AI-GRS, Tony Sevelka, MAI, SRA, AI-GRS, Justin Slack,
MAI, Michael V. Tankersley, MAI, SRA, AI-GRS, AI-RRS, John H. Urubek, MAI,
AI-GRS, Stephen Wagner, MAI, AI-GRS, Joshua Wood, MAI, AI-GRS, and Larry T.
Wright, MAI, SRA, AI-GRS.
The following contributors deserve additional recognition for reviewing the
entire manuscript of this edition of the textbook: Stephanie Coleman, Stephen Roach,
and Leslie Sellers. Their contribution to the book’s development—and patience with
the process—are greatly appreciated.
Introduction to Appraisal 1
A real estate developer visits a plot of vacant land near a suburban highway inter-
change and makes some rough calculations about the feasibility of building and leas-
ing an office building on the site in the next two years. A residential real estate broker
with the listing for a three-bedroom, two-bathroom house in an active urban market re-
searches the prices paid recently for homes of a similar size with similar physical char-
acteristics before suggesting a listing price to the seller. Another broker looks through
the multiple listing service before showing a young couple homes for sale in nearby
suburban neighborhoods that are within the couple’s price range. What do these situa-
tions have in common? They all involve decisions about real estate and its value.
A county tax assessor runs data for hundreds of properties through a battery of
statistical models as part of the three-year reassessment of commercial real estate in
the municipality. A loan officer at a branch of a regional bank looks over a loan ap-
plication and several supporting documents as part of the due diligence in making
a recommendation on construction financing for the expansion of a local manufac-
turing company’s office-warehouse. An attorney represents the owner of farmland
adjacent to a county road in a dispute with the county department of transportation
over the amount of just compensation due for land taken as part of a road improve-
ment project.
Clearly, all the individuals in these scenarios are making decisions about real
estate based on their perceptions of the value of an individual property or a group of
properties in a specific market. However, none of these key participants in the real
estate marketplace is performing an appraisal.
What Is an Appraisal?
In simplest terms, an appraisal is “the act or process of developing an opinion of
value” of an asset.1 The asset in question could be anything—fine art, machinery and
1. As a technical term, appraisal is defined similarly in professional standards and regulations such as the Appraisal Foundation’s Uniform Standards
of Professional Appraisal Practice and the Appraisal Institute’s Code of Professional Ethics and Standards of Valuation Practice.
equipment, or even a specific type of business. The focus of this book, however, is the
appraisal of real property, i.e., rights in real estate.
The value developed in an appraisal is a measure of the relative worth of the as-
set, expressed in terms of money. In other words, the property appraisal quantifies to
a certain level of precision what buyers and sellers would consider the relative worth
of an identified interest in a parcel of land and any improvements to that land.
Implicit in the traditional definition of appraisal is the idea that an appraisal is
someone’s opinion, rather than a fact. A useful way to think about what an appraisal
is would be to look more closely at the people who develop those opinions of value.
While anyone can have an opinion of value, appraisers are professionals with train-
ing and expertise in accepted valuation methods and techniques who have an ethical
obligation to remain disinterested and unbiased while performing an appraisal.
That professional expertise gives the value opinion of an appraiser credibility in the
marketplace, which the opinions of other market participants do not have. And what
makes the appraiser’s opinion more valuable to clients is knowledge and experience,
combined with an unbiased analytical process, supported by relevant evidence and
logic, and resulting in credible value conclusions.
In the United States, licensed and certified real estate appraisers meet educational,
experience, and testing requirements set by states and can perform appraisals in the
jurisdiction covered by their licensing credentials. The federal government has man-
dated that all states establish licensing and certification programs to regulate appraisals
for federally related transactions (i.e., certain real estate–related financial transactions
involving federally insured depository institutions). Some states have established laws
requiring licensing or certification only for appraisals performed for these purposes,
while other states require licensing or certification for appraisals performed for any (or
almost any) purpose. In general, the courts do not require an appraiser to be licensed or
certified. However, possession of a state-issued license or certification has become a ba-
sic indication of appraiser competency. Outside the United States, appraisers are com-
monly known as valuers. Unsurprisingly, the professional qualifications of valuers vary
from country to country, often depending on the nature of the economic system and the
history and development of the valuation profession within a particular country.2
Professional standards, such as the Appraisal Institute’s Standards of Valuation
Practice (SVP), the Uniform Standards of Professional Appraisal Practice (USPAP),
and the International Valuation Standards (IVS), highlight the ethical codes that valu-
ation professionals must follow. For example, USPAP defines an appraiser as “one
who is expected to perform valuation services competently and in a manner that is
independent, impartial, and objective.” By that definition, any potential client of an
appraiser should be able to expect a certain level of professionalism from anyone
representing himself or herself as an appraiser. Similarly, the International Valuation
Standards outline the expected objectivity of valuers as follows:
The process of valuation requires the valuer to make impartial judgements as to the reliability of
inputs and assumptions. For a valuation to be credible, it is important that those judgements are
made in a way that promotes transparency and minimises the influence of any subjective factors
on the process. Judgement used in a valuation must be applied objectively to avoid biased analy-
ses, opinions and conclusions.3
2. For a discussion of licensing criteria in specific countries, see Howard C. Gelbtuch with Eunice H. Park, Real Estate Valuation in Global Markets,
2nd ed. (Chicago: Appraisal Institute, 2011).
3. International Valuation Standards 2017 (London: International Valuation Standards Council, 2017), 6.
2 The Appraisal of Real Estate

The Code of Professional Ethics of the Appraisal Institute echoes those other stan-
dards documents, defining a valuer as “[o]ne who is expected to provide [s]ervices in
an unbiased and competent manner.”
Real property appraisers have extensive training and experience and are com-
mitted to the profession. Appraisers are bound to strict compliance with regulatory
requirements, and many are members of appraisal organizations that encourage
participation in professional activities and educational development. Members agree
to peer review of their ethical conduct and work performance, which reflects their
strong commitment to professionalism. Like many other professions, the appraisal
profession encompasses specific areas of expertise, and some areas of appraisal work
require significant training and experience. Competency is a key factor in every ap-
praisal assignment.
Continuing education is the cornerstone of professional development. By pursu-
ing continuing education, appraisers demonstrate their commitment to maintaining
their skills at a level far above the bare minimum required to satisfy state credential-
ing requirements. Individuals who complete a rigorous educational program and
earn recognized professional designations find that their employment and business
prospects are considerably enhanced. A commitment to professionalism helps regu-
late the industry and ensures quality appraisal work.
Services relating to the value of property are provided by a variety of profession-
als and others. The services provided by appraisers (valuers) are known as “appraisal
practice” or “valuation practice.” These services include appraisal and review, as well
as a wide range of activities such as measuring the size of buildings and developing
detailed market studies. When performed by an appraiser, the client can expect these
services to be provided competently and in a manner that is independent, impartial,
and objective—as these are the characteristics that define an appraiser.
What Is Real Property?

Precisely what does a real estate appraiser value? In simplest terms, real property
rights are valued, not the real estate itself. In real estate appraisal, an important dis-
tinction is made between the terms real estate and real property. Although some laws
and court decisions treat the terms synonymously for legal purposes, in appraisal
practice the terms real estate and real property are distinctly different.
Real estate is the physical land and appurtenances affixed to the land—e.g.,
structures. Real estate is immobile and tangible. Real estate includes the following
tangible components:
• Land
• All things that are a natural part of land, such as trees and minerals
• All things that are attached to land by people, such as buildings and site im-
provements
In addition, all permanent building attachments (for example, plumbing, electrical
wiring, and heating systems) as well as built-in items (such as cabinets and elevators)
are usually considered part of the real estate. Real estate includes all attachments, both
above and below the ground.
Real property includes the interests, benefits, and rights inherent in the owner-
ship of physical real estate. In an appraisal, a particular set of real property inter-
ests—not the real estate—is what is valued. Real estate
The distinction between real in and of itself has no value. The rights, or interests, in
estate and real property is
fundamental to appraisal: real estate are what have value.
real estate The terms estate and interest may be used differ-
An identified parcel or tractently depending on the jurisdiction or the discipline. In
of land, including improve- valuation practice, an estate is what is owned, includ-
ments, if any. ing the right of possession and the power to exclude
real property others. Interests are rights in real property; they can
The interests, benefits, and benefit or burden the land and affect the value of an
rights inherent in the owner-estate. What is usually valued is an estate subject to
ship of real estate. specified interests. Therefore, the appraiser’s task is to
identify not only the estate (fee simple estate, leasehold
estate, life estate) but also the interests associated with
the real estate, such as leases, easements, restrictions,
encumbrances, reservations, covenants, contracts, declarations, special assessments,
ordinances, or other items of a similar nature. In some assignments, interests alone
are valued. For example, the subject of the appraisal may be an easement.
The Bundle of Rights

The total range of private ownership interests in real property is called the bundle
of rights. Imagine a bundle of sticks in which each “stick” represents a distinct and
separate right or interest. The bundle of rights contains all the interests in real prop-
erty, including the right to use the real estate, sell it, lease it, enter it, and give it away.
Constitutional, statutory and common law provides for the private enjoyment of
these rights, subject to certain limitations and restrictions.
Public Restrictions on Ownership

In the United States, private ownership of real property rights is guaranteed by the
US Constitution but is subject to certain government restrictions, known as the four
powers of government:
• Taxation
• Eminent domain
• Police power
• Escheat
Taxation is the right of government to raise revenue through assessments on
goods, products, and rights. The US Constitution effectively precludes the federal
government from taxing real property directly, although the income and proceeds
from the sale of real property may be subject to federal income taxation. The right to
tax property is reserved for state and local governments.
Eminent domain is the right of government to take private property for public
use upon the payment of just compensation. This right can be exercised by a govern-
ment agency or by an entity acting under governmental authority such as a housing
authority, school district, park district, or right of way agency. Condemnation is the
act or process of enforcing the right of eminent domain.
Police power is the right of government through which property is regulated to
protect public safety, health, and general welfare. Examples of police power include

zoning ordinances, use restrictions, building codes, air
and land traffic regulations, health codes, and environ- taxation
mental regulations. The right of government
to raise revenue through
Escheat is the right of government that gives the assessments on valuable
state or a local government (e.g., township or county) goods, products, and rights.
titular ownership of a property when the owner dies eminent domain
without a will or any statutory heirs. That is, the gov- The right of government to
ernment does not take the property but becomes the take private property for pub-
recipient of the real property if there are no other heirs lic use upon the payment of
to be found. just compensation. The Fifth
Amendment of the US Con-
stitution, also known as the
Private Restrictions on Ownership takings clause, guarantees
Private restrictions on property ownership can limit payment of just compensa-
the use or development of a property and might limit tion upon appropriation of
the manner in which ownership can be conveyed. The private property.
purchaser of a property may be obligated to use the police power
property subject to a private restriction such as right The inherent power of govern-
ment to regulate property in
of way or a party-wall agreement. Deed restrictions order to protect public health,
and subdivision covenants and restrictions can often safety, and general welfare.
be found in deeds recorded at the county courthouse, escheat
which are often available online. Alternatively, infor- The right of government that
mation on those restrictions might be provided by a gives the state titular owner-
property owner. Restrictions such as easements and ship of a property when its
rights of way may be more difficult to uncover. They owner dies without a will or
any ascertainable heirs.
may be found in title reports or through a diligent
search of public records. Sometimes the owner, cli-
ent, broker, or neighbors can provide this information.
Discovering other restrictions such as an unrecorded
agreement relative to water rights may be a more daunting task.
Non-realty Assets
Appraisers not only recognize the distinction between real estate and real property,
they also identify any non-realty items that are included in the valuation. Non-realty
items include tangible and intangible personal property and, in some cases, financial
assets. The identification of these items is part of the first step in the valuation process.
(See Chapter 4.) Valuation standards do not require the separate valuation of non-realty
items, but the assignment may call for these items to be valued separately. The appraisal
report must identify any non-realty items and address their effect on value, even when
those items are not valued separately. If an assignment calls for non-realty items to be
valued separately, an appraiser must (a) ascertain whether he or she possesses the requi-
site competency, (b) follow the applicable valuation standards, and (c) properly identify
the type of value developed. The valuation of non-realty assets is a specialized assign-
ment requiring additional competency, which is discussed in more detail in Chapter 37.
Sometimes an appraisal assignment involves just the real property, e.g., interests
in the land, building, and fixtures such as plumbing, lighting, heating, and air-condi-
tioning systems. At other times, the appraisal may include non-realty items such as
personal property or financial assets either instead of or in addition to the real prop-
erty. For example, an appraisal assignment involving a service station might include
the valuation of the real property and personal property such as trade fixtures (e.g.,
fuel pumps installed by the tenant that will be removed at the expiration of the lease).
Why Appraisals Are Needed

Appraisals are requested for as many different reasons as there are clients. (Figure 1.1
does not reflect all possible uses for appraisals, but it does provide a broad sampling
of professional appraisal activities.) All the scenarios outlined at the beginning of the
chapter involve significant financial decisions that might require an appraisal and
therefore an appraiser. Appraisals are often required by law, such as in many lending
situations. Traditionally, appraisals for mortgage lending have been the bulk of work
for appraisers of residential property, although the advent of automated valuation
models (AVMs) in the 1990s has created competition in that market segment.4
Changes in governmental regulations relating to mortgage lending can have
a significant effect on the amount of work appraisers have. As another example, a
condemning authority typically must retain an appraiser to value a property that is
taken through the exercise of the governmental power of eminent domain as support
for the amount of just compensation payable to the property owner. Indeed, in most
situations in which the value of real property is contested in court, appraisals serve
as primary support and appraisers are commonly summoned to testify as expert wit-
nesses on matters relating to the value of real property.
When an appraisal is not required by law, it may be desired by a client because
the appraiser’s opinion is objective and unbiased and the information about the
value of real property will be useful in a financial decision. For example, a property
owner might order an appraisal to set an offering price for the property that will
attract buyers and would likely be competitive in the market without a significant
marketing period.
Just as appraisers must be aware of the differences between types of property,
they must also be able to identify which type of value is appropriate for the client’s
needs. Like the interest to be appraised, the type of value sought must be identified
and defined at the outset of an appraisal assignment. The most common appraisal
assignments involve developing an opinion of market value, but many other types of
value might be the focus of an appraisal such as
• Use value
• Investment value
• Disposition value and liquidation value
• Assessed value
• Insurable value
• Fair value
The type and definition of value appropriate for a particular assignment will often be
clear to experienced appraisers. Technical distinctions among the types and defini-
tions of value listed above are discussed in Chapter 6.
4. See Chapter 14 for more discussion of automated valuation models.

Figure 1.1 Range of Uses of Appraisals
Transfer of Ownership
• To help prospective buyers set offering prices
• To help prospective sellers agree on acceptable selling prices
• To establish a basis for real property exchanges
• To establish a basis for reorganizing or merging the ownership of multiple properties
• To determine the terms of a sale price for a proposed transaction
Financing and Credit
• To develop an opinion of the value of the real property offered as collateral for a proposed mortgage loan
• To provide an investor with a sound basis for deciding whether to purchase real estate mortgages, bonds, or other
types of securities
• To establish a basis for a decision to insure or underwrite a loan on real property
Litigation
Eminent domain proceedings
• To develop an opinion of the market value of a property as a whole—i.e., before an acquisition
• To develop an opinion of the market value of the remainder after a partial taking
• To estimate the damages to a property created by a taking
Property divisions
• To develop an opinion of the market value of a property in contract disputes
• To develop an opinion of the market value of real estate as part of a portfolio
• To develop an opinion of the market value of partnership interests
Real estate litigation
• To estimate damages created by violations of environmental laws
• To estimate damages created by environmental accidents
• To estimate damages due to construction defects or defects in title
• To determine professional liability (of a broker, attorney, appraiser, or other professional)
• To help settle bankruptcy cases and the dissolution of business partnerships and marriages
Tax matters
• To develop an opinion of assessed value or another type of value
• To separate assets into depreciable (or capital recapture) items such as buildings and nondepreciable items such
as land, and to estimate applicable depreciation (or capital recapture) rates
• To develop an opinion of the value of the real estate component of an estate plan that represents the foundation
for future capital gains and inheritance taxes
• To develop an opinion of value used in determining gift or inheritance taxes
• To develop an opinion of value of conservation easements
Investment Counseling, Decision Making, and Accounting
• To develop an opinion of fair value for financial reporting
• To set rent schedules and lease provisions
• To determine the feasibility of a construction or renovation program
• To help an investor trade an interest in a corporation that holds real property
• To help corporations or third parties purchase homes for transferred employees
• To serve the needs of insurers, adjusters, and policyholders
• To facilitate corporate mergers, the issuance of stock, or the revision of book value
• To develop an opinion of liquidation value for forced sale or auction proceedings
• To counsel clients by considering their investment goals, alternatives, resources, constraints, and the timing of their
activities
• To advise zoning boards, courts, and planners, among others, on the probable effects of proposed actions
• To assist in arbitrating valuation issues
• To analyze supply and demand trends in a market
• To identify the current status of real estate markets
• To value fixed assets and assist in asset value allocations
Land, Real Estate, and 2
Ownership of Real Property
According to an old saying, “Under all is the land.” Land provides the foundation for
the social and economic activities of people. It is both a tangible physical commodity
and a source of wealth. Because land is essential to life and society, it is the subject of
many disciplines, including law, economics, finance, sociology, and geography. With-
in the vast domain of the law, issues relating to the ownership and the use of land are
considered. In economics, land is regarded as one of the four agents of production,
along with labor, capital, and entrepreneurial coordination, and land provides the
natural elements that contribute to a nation’s wealth. Finance applies the principles
of economics within a market economy that furnishes capital for the exchange of
property, and financial considerations help market participants act knowledgeably
and prudently. From a sociological perspective, land is a resource to be shared by all
people, and land is also a commodity that can be owned, traded, and used by indi-
viduals, corporations, partnerships, and other entities. Geography focuses on de-
scribing the physical elements of land and the activities of the people who use it.
Lawyers, economists, sociologists, and geographers have a common understand-
ing of the attributes of land:
• Each parcel of land is unique in its location and composition.
• Land is physically immobile.
• Land is durable.
• The supply of land is finite.
• Land is useful to people.
Real estate appraisers recognize the attributes that Land is investigated and
form the basis for real property value. In contrast to the analyzed in a variety of
disciplines—government, the
physical character of land, land value is an economic law, economics, geography,
concept. Appraisers recognize the concepts of land environmental studies, engi-
used in other disciplines but are most concerned with neering, and land planning.
how the market measures land value. Markets reflect
the attitudes and actions of people in response to social and economic forces and the
constraints of law and legal encumbrances.
Concepts of Land
Although land and improvements on and to land can be viewed in a physical sense,
there are other concepts of land that are less obvious. These concepts help to charac-
terize the importance of land and provide the foundation for land value systems.
Geographic and Environmental

The study of land includes consideration of its diverse physical characteristics and
how these characteristics combine in a particular area. Each land parcel is unique,
and a fixed location is a prominent characteristic of all real estate. The utility of land
and the highest and best use to which land can be put are significantly affected by the
physical and locational characteristics of the land and other related considerations,
broadly referred to as geography.
Land is affected by a number of processes. Ongoing physical processes modify
the land’s surface, biological processes determine the distribution of life forms, and
socioeconomic processes affect human habitation and activity on the land. Together,
these processes influence the characteristics of land use.
Land can be used for many purposes such as
• Agriculture
• Commerce
• Industry
• Residence
• Recreation
• Transportation and infrastructure
And land use decisions may be influenced by many factors including
• Climate
• Topography
• The distribution and density of natural resources, population centers, and industry
• Trends in economics, population, technology, and culture
The influence of each of these factors on a particular parcel of land varies.
Geographic considerations are particularly significant to appraisers. The impor-
tance of physical characteristics such as topography, soils, water, and vegetation is
obvious, but the distribution of population, facilities, and services and the movement
of people and goods are important as well. The geographic concept of land, which
emphasizes natural resources, the location of industry, and actual and potential mar-
kets, provides much of the background knowledge required in real estate appraisal.
Legal
Land use reflects the needs and values of organized society. To understand how the
various forces affecting land operate, the basic role of law must be recognized. The
cultural, political, governmental, and economic attitudes of a society are reflected
in its laws. The law does not focus on the physical characteristics of land but on the

rights and obligations associated with various interests Land “to the Sky and
in land. In the United States, the right of individuals the Depths”
to own and use land for material gain is maintained,
while the right of all people to use the land is protected.
In other words, the law recognizes the possible conflict
between private ownership and public use.
“Whose is the land, his it is, to the sky and the
depths.” This ancient maxim is the basis of the follow-
ing legal definition:
Land . . . includes not only the ground, or soil, but everything
that is attached to the earth, whether by course of nature, as are
trees and herbage, or by the hand of man, as are houses and
other buildings. It includes not only the surface of the earth but
everything under it and over it. Thus in legal theory, the surface
of the earth is just part of an inverted pyramid having its tip,
or apex, at the center of the earth, extending outward through
the surface of the earth at the boundary lines of the tract, and
continuing on upward to the heavens.1
This definition suggests that land ownership includes complete possession of land
from the center of the earth to the ends of the universe. In practice, however, the
rights available to private ownership are legally limited due to governmental controls.
The US Congress has declared that the federal government has exclusive sover-
eignty over the nation’s airspace and that every citizen has a public right of transit
through the navigable airspace in the United States.2 Many states restrict ownership
and use of subsurface areas such as underground aquifers and oil and gas reserves.
Because land ownership can be limited, ownership rights are the subject of law. For
example, state laws will determine if it is permissible for the owners of a parcel of
land to drill a well on their property that draws water from an aquifer located under
neighboring land. The lawful entitlement to access underground water resources in
this example is a valuable ownership right in land. These types of rights are the focus
of real property appraisal.
The laws that govern the use and development of land in the United States give
landowners great freedom in deciding how to use their land. However, this freedom
is not without restrictions. The basic concept of private ownership calls for unrestrict-
ed use so long as that use does not unreasonably harm the rights of others. In the
past, the test of harm focused on owners of adjacent properties. The concept of harm
has been expanded to encompass broader social and geographic concerns. The defini-
tion of reasonable use has been argued in many court cases.
Legal matters of particular concern to appraisers include the following:
• Easements
• Access regulations
• Water and mineral rights
• Zoning, environmental laws, building codes, and other use restrictions
• The recording and conveyance of titles
1. Raymond J. Werner and Robert Kratovil, Real Estate Law, 10th ed. (Englewood Cliffs, NJ: Prentice-Hall, 1993), 4.
2. 49 USC §40103. Sovereignty and Use of Airspace.
Land, Real Estate, and Ownership of Real Property 11

Appraisers should be familiar with local and state laws, which have primary jurisdic-
tion over land. Most communities have zoning laws, and specific districts within that
community may be part of overlay zones where some properties have another layer
of restrictions.
Economic
Land is a physical entity with inherent ownership rights that can be legally limited
for the good of society. Land is also a major source of wealth, which, in economic
terms, can be measured in money or exchange value. Land and its products have
economic value only when they are converted into goods or services that are useful,
desirable, paid for by consumers, and limited in supply. (A product with an essential-
ly unlimited supply such as oxygen will have a low value.) The economic concept of
land as a source of wealth and an object of value is central to appraisal theory. There
is a long history of thought on the sources and bases of value, which is referred to as
value theory.
Value is a reflection of the amount of income that land can generate for a proper-
ty owner or how much benefit a combination of land and improvements can provide.
Many commercial properties produce income for their owners. Commercial proper-
ties that are owner-occupied remove or restrict the potential for rental income flow-
ing to the owner, but an owner-occupied property has value in how it is used. That
use may exceed the cost of leasing similar space for the owner’s business needs. Eco-
nomic concepts contribute to the value definitions used in appraisals, and they are an
important part of the literature on which professional appraisal practice is founded.
One facet of value is the present net worth of future benefits, and those benefits can
often be quantified in terms of rental income.
Social
Modern society has become increasingly concerned with how land is used and how
rights are distributed. The supply of land is fixed, so increased demand for land
creates the need for land to be used more intensively. Conflicts often arise between
groups that hold different views on proper land use. Some believe that land is a
resource to be shared by all. Some want to preserve the land’s scenic beauty and im-
portant ecological functions. Others view land primarily as a marketable commodity;
they believe society is best served by private, unrestricted ownership. For example,
the developer of a proposed shopping center or business park may view the develop-
ment of a particular parcel of land in a desirable and affordable location as serving a
definable market area. On the other hand, local residents may argue that, as the site
of a significant Civil War battle, the parcel deserves government protection (if taxpay-
ers can be persuaded to support such a public investment in historical preservation).
These conflicting views reflect controversies that arise between the property rights of
the individual and those of society. As a resource, land may be protected for the good
of society. As a marketable commodity, the ownership, use, and transfer of land are
regulated so that individual rights are not violated.3
Throughout American history, land ownership has been recognized as a founda-
tion of the country’s democratic institutions. John Adams wrote, “If the multitude is
3. See also Charles E. Roe, “Land Use: The Second Battle of Gettysburg,” The Appraisal Journal (October 2000): 441-449.

possessed of real estate, the multitude will take care of the liberty, virtue, and interest
of the multitude in all acts of government.”4
All laws and operations of government are intended to benefit the public. Thus,
in the public interest, society may impose building restrictions, zoning and building
ordinances, development and subdivision regulations, and other land use controls.
These controls affect what may be developed, where development may occur, and
what activities may be permitted subsequent to development. Since the 1960s, the
federal government, in cooperation with the states, has increased its efforts to regu-
late the air and water emissions from manufacturing processes and to reduce pollu-
tion caused by dirt, chemicals, and noise. Land use regulations have been expanded
to wetlands, beaches, and navigable waters and to preserve the habitats of endan-
gered species.5
As the nature and extent of land use controls change, so do the nature and extent
of private land ownership. Land use regulations vary. In more densely populated
areas, there is a greater need to control land uses. Changes in land use regulations
affect markets and ultimately real estate values. Consequently, real estate apprais-
ers must be familiar with the regulations and restrictions that apply to land use and
understand how these regulations affect a specific property.
Public and Private Forms of Real Property Ownership

One major distinction in real property ownership is the difference between private
ownership and public ownership. Public ownership of real property takes many
forms. Streets and roads, municipal utility systems, and other public facilities such
as city halls, prisons, and public works facilities are usually owned by governmental
bodies for the benefit of all citizens in a jurisdiction. School districts own land on
which school buildings, athletic fields, and other facilities are maintained. Library
districts create public libraries. Park, recreation, and conservation districts acquire
land for recreation, conservation, and preservation.
Most public ownership is created in response to public necessity or public
demand. For example, in one community it might be necessary to acquire land for
a school using the power of eminent domain. In another community, there might be
sufficient demand by residents for the municipality to acquire land for the develop-
ment of soccer fields using money generated by real estate taxes. Rather than being
concerned with the economic issues that are of importance to private owners of real
property, a governmental entity often is more concerned with how publicly owned
real property, which is usually not subject to real estate taxation, can be used in the
best interests of the public.
Police power also regulates land use, and often its application can reflect the
difference in a property viewed from the perspective of public ownership versus
private ownership. For example, a large municipal park might be an ideal location
for industrial development, but the zoning imposed through the application of police
power will ensure that the park continues to be used for recreational purposes. Also,
government regulations will dictate how property acquired by a governmental entity
through the process of escheat will best benefit the general public.
4. 94 U.S. 113. Quoted in “Land as a Commodity” by Babcock and Feurer in Andrews, Land in America, 31.
5. For more information on the government’s control of land use, see Real Property Valuation in Condemnation (Chicago: Appraisal Institute, 2018).
Land, Real Estate, and Ownership of Real Property 13

Although many appraisal assignments involve the valuation of publicly owned
real property, most involve the valuation of private ownership interests. As discussed
in this chapter, ownership of property can take many forms. How title to a property
is held is usually selected based on the needs of the owner or owners. For example,
title to a one-unit residence might be held by two spouses in joint tenancy with the
right of survivorship. For a chain of food stores, however, title might be held as a
beneficial interest in a land trust or a limited liability corporation.
Professional appraisal standards require appraisers to identify the interest to be
valued in an assignment, but the interest valued need not reflect what is currently
held by any particular entity. For example, an appraiser can value a fee simple inter-
est even though the property is leased. The interest appraised depends on the intend-
ed use of the appraisal and what interest the client needs to have valued. Chapter 7
covers the forms of ownership entities in more detail.

The Nature of Value 3
The History of Value Theory

The development of modern value theory began in the eighteenth and nineteenth
centuries when economic thinkers of the classical school first identified the four
agents of production—labor, capital, coordination, and land—and examined the
relationships between the basic factors that create value and supply and demand, i.e.,
utility, scarcity, desire, and effective purchasing power. Classical theory was largely
based on the contributions of the physiocrats, whose ideas were put forth in reaction
to the mercantilist doctrines that dominated earlier economic thought.
Mercantilism focused on wealth as a means of enhancing a nation’s power.
National wealth was equated with an influx of bullion into the national treasury.
Mercantilists sought to maintain a favorable balance of trade by selling goods to ac-
cumulate gold, the chief medium of exchange. Between the fifteenth and eighteenth
centuries, economic activity in western Europe was associated with overseas explo-
ration, colonization, and commerce. Mercantilist doctrine promoted strong, central
economic controls to maintain monopolies in foreign trade and ensure the economic
dependency of colonies.
Physiocratic thinkers of the mid-eighteenth century objected to the commercial
and national emphasis of mercantilism. They stressed other considerations in for-
mulating a theory of value. Agricultural productivity, not gold, was identified as
the source of wealth, and land was cited as the fundamental productive agent. The
physiocrats also identified the importance of factors such as utility and scarcity in
determining value.
The Classical School

The classical school expanded and refined the tenets of physiocratic thought, for-
mulating a value theory that attributed value to the cost of production. The Scottish
economic thinker Adam Smith (1721-1790) suggested that capital, in addition to land
and labor, constituted a primary agent of production. Smith acknowledged the role of
coordination in production but did not study its function as a primary agent. He be-
lieved that value was created when the agents of production were brought together
to produce a useful item.
In The Wealth of Nations (1776), the first systematic treatment of economics, Smith
considered value as an objective phenomenon. By virtue of its existence, an item
was assumed to possess utility. Scarcity also added exchange value to goods. The
“natural price” of an object generally reflected how much the item cost to produce. In
contemporary appraisal practice, the classical theory of value is evidenced in the cost
approach. For example, if the cost of a new housing unit plus the price of the land is
more than the market will pay for the property, few new units will be produced.
Later economic thinkers of the classical school offered theoretical refinements on
the cost of production theory of value, but none contested its basic premises. David
Ricardo (1772-1823) in On the Principles of Political Economy and Taxation (1817) devel-
oped a theory of rent based on the concept of marginal land and the law of diminish-
ing returns. Land residual returns were referred to as “rent.” Ricardo’s theory has
contributed significantly to the concept of highest and best use and the land residual
technique used in the income capitalization approach to value.
John Stuart Mill (1806-1873) reworked Adam Smith’s ideas in The Principles of
Political Economy (1848), which became the leading economic text of its time. Mill
defined the relationship between interest and value in use, which he referred to as
“capital value”; the role of risk in determining interest; and the inequities of “un-
earned increments” accruing to land. Confident in his analysis of the cost of produc-
tion theory, Mill asserted, “Happily, nothing in the laws of value remains for the
present or any future writer to clear up; the theory of the subject is complete.”
Challenges to Classical Value Theory

In the second half of the nineteenth century, two serious challenges to classical value
theory were put forward. One was the labor theory of value, an extreme position
advocated by Karl Marx (1818-1883). Marx claimed that all value is the direct result
of labor and that increased wages to labor would lower capitalistic profits. Marx
envisioned an inevitable struggle between the social classes that would eventually
result in a violent political upheaval.
The other challenge was presented by the marginal utility, or Austrian, school,
which was critical of both the classical and Marxian theories. The central concept of
marginal utility links value to the utility of and demand for the marginal, or addi-
tional, unit of an item. Thus, if one more unit than is needed or demanded appears
in a given market, the market becomes diluted and the cost of production becomes
irrelevant. Value is regarded as a function of demand, with utility as its fundamental
precept.1 Marginal utility is the theoretical basis for the concept of contribution.
The Neoclassical Synthesis

These formidable challenges to the classical theory of value inspired economists to
reconsider the issue. In the late nineteenth and early twentieth centuries, the neoclas-
sical school successfully merged the supply-cost considerations of the classicists with
1. Eugen von Boehm-Bawerk (1835-1882) defined value as “the significance a good acquires by contributing utility toward the well-being of an
individual.” William Stanley Jevons (1835-1882), a founder of modern statistics and a principal proponent of marginal utility, wrote, “Labor once
spent has no influence on the future value of any article: it is gone and lost forever.” W. Stanley Jevons, The Theory of Political Economy, 5th ed.
(New York: Augustus M. Kelley, 1965).

the demand-price theory of marginal utility. Alfred Marshall (1842-1924) is credited
with this synthesis, which forms the basis for contemporary value theory.2
Marshall compared supply and demand to the blades of a pair of scissors be-
cause neither concept could ever be separated from the determination of value. He
stressed the importance of time in working out an adjustment between the two prin-
ciples. Marshall maintained that market forces tend toward an equilibrium where
prices and production costs meet. Utility-demand considerations operate in the
limited span of a given market. In the short term, supply is relatively fixed and value
is a function of demand. Cost-supply considerations, however, extend over a broader
period, during which production flows and patterns are subject to change. Marshall
believed that a perfect economic market would eventually result, and that price, cost,
and value would all be equal.
Marshall was the first major economist to consider the techniques of valuation,
specifically the valuation of real estate. In this regard, his writings and the writings of
those who built upon his work are the source of the distinction between value theory
and valuation theory—i.e., the method of estimating, measuring, or forecasting a
defined value. Marshall anticipated and developed many of the concepts employed
in contemporary appraisal practice. These concepts include the development of an
opinion of site value through capitalization of income, the impact of depreciation on
buildings, and the influence of different building types and land uses on land value.
Marshall is also credited with identifying the three traditional approaches to
value: market (sales) comparison, reproduction or replacement cost, and capitaliza-
tion of income. Irving Fisher (1867-1947), an influential American economist associ-
ated with the neoclassical school, fully developed the income theory of value, which
is the basis for the income capitalization approach used by modern appraisers.
Modern Appraisal Theory

The writings of Marshall, Fisher, and other economists of the late nineteenth and
early twentieth centuries were read by scholars and business professionals interested
in economic thought. At the same time, the field of real estate appraisal was emerg-
ing and a few practitioners were gaining experience estimating market value and
other kinds of value for properties of various types. In the 1920s and 1930s, several
events helped to establish appraisal as a young, but viable, profession.
One motivating force was the introduction of land economics as an academic dis-
cipline. Land economics developed from the interrelationship of several disciplines
and attracted scholars and students who contributed significantly to real estate and
appraisal literature over the next 40 years.3
A significant event in appraisal history was the publication of Real Estate Apprais-
ing by Arthur J. Mertzke in 1927, which adapted Alfred Marshall’s ideas to develop a
tangible link between value theory and valuation theory. Mertzke translated eco-
nomic theory into a working appraisal theory, helped establish a clear emphasis on
2. In 1890, Marshall published Principles of Economics, which succeeded Mill’s Principles of Political Economy as the authoritative text on economic
thought. In this book, Marshall advocated a dynamic theory of value to explain real world events. See Alfred Marshall, Principles of Economics,
8th ed. (London: MacMillan and Company, 1920); reprint (Philadelphia: Porcupine Press, 1982), 288-290, 664-669.
3. This influential group included Richard T. Ely (1854-1943), the founder of land economics as an academic subject, Frederick Morrison Babcock
(1898-1983), Ernest McKinley Fisher (1893-1981), and Arthur J. Mertzke (1890-1970). Ely, Babcock, and Fisher contributed to the Land Economics
series published by the National Association of Real Estate Boards (now the National Association of Realtors), which was the first major publica-
tion effort designed to provide real estate professionals with current technical information. The first texts in this series were Fisher’s Principles of
Real Estate (1923), Ely and Moorehouse’s Elements of Land Economics (1924), and Babcock’s The Appraisal of Real Estate (1924).

the three approaches to value, and explained the use of capitalization rates as indexes
of security. The preeminence of the three approaches to value in the appraisal process
was underscored in publications by K. Lee Hyder, Harry Grant Atkinson, and George
L. Schmutz.4 Their works set forth systematic procedures for applying the sales
comparison, cost, and income capitalization approaches. Schmutz presented a model
in which appraisal activity leads to a conclusion of value, which was later incorpo-
rated into The Appraisal of Real Estate, first published by the American Institute of Real
Estate Appraisers in 1951.
Appraisal theory and the language used to describe that theory have continued
to evolve. Today’s education requirements are stringent, and appraisers make use of
many analytical methods and techniques.
Agents of Production
The production of goods, services, and income depends on the combined effects of four
essential economic ingredients, which are referred to as the four agents of production:
1. Land
2. Labor
3. Capital
4. Entrepreneurial coordination
The four agents of production contribute to the creation of real estate, and the sum
of the costs to develop a property is one of the basic measures of real property value
available to appraisers. In other words, a finished real estate product is created by
combining land, labor, capital, and entrepreneurial coordination. A well-supported
opinion of value can be derived through systematic analysis of each of these compo-
nents, their interrelationships, and their relationship to the property as a whole.
Land
The first thing an entrepreneur generally considers in developing a property is the
cost of acquiring the land. Market participants anticipate that improvements may be
added to land and that the property may be marketed to tenants or end users. Before
the land can be developed, it may need to be improved physically (e.g., by filling,
shaping, draining, servicing) and legally (e.g., by rezoning or by securing necessary
development and building approvals), which will require labor, capital, and entrepre-
neurial effort.
Labor
The labor component is the physical and intellectual contribution of workers to the
production process. Along with land, labor is considered a primary factor of produc-
tion because neither is the result of the economic process. The quality of the physical
and mental work involved in producing goods and services is a result of the skills,
education, and motivation of the workforce. The productivity of labor as an agent of
production increases with the quality of that labor.
4. K. Lee Hyder, “The Appraisal Process,” The Appraisal Journal (January 1936); Harry Grant Atkinson, “The Process of Appraising Single-Family
Homes,” The Appraisal Journal (April 1936); and George L. Schmutz, The Appraisal Process (North Hollywood, CA: the author, 1941).

Capital
entrepreneurial coordination
Real estate development requires physical capital such
The ability of an entre-
as equipment (machinery and tools), buildings (and preneur to combine land,
all building components), and infrastructure (that is, labor, and capital in the
capital goods). The category of capital goods represents development of real estate;
produced goods that can be used as factor inputs for a component of real property
further production. As such, capital exists as a result of value that represents the
investment of time and
the economic process. expertise in the development
of a property.
Entrepreneurial Coordination
No prudent real estate developer will undertake to
construct and market a property without anticipating
a profit in addition to the return of the equity investment. A property buyer who
continues an existing land use is not creating value, only maintaining value through
proper management of the property. A developer, on the other hand, invests not only
equity in a development but also time and expertise. Accordingly, an entrepreneur
expects a reward—known as entrepreneurial incentive and measured in the market-
place as entrepreneurial profit—for creating and marketing a real estate product
through the coordination of land, labor, and capital and for taking on the risk inher-
ent in the undertaking. More precisely, entrepreneurial incentive is a forecast of the
amount the developer expects to receive. This forecast is developed before con-
struction is complete. Entrepreneurial profit is the actual amount received after the
property is complete. The fourth agent of production, entrepreneurial coordination,
accounts for that investment of time and expertise. (Entrepreneurial incentive and
entrepreneurial profit are discussed in greater detail in Chapter 29.)
Factors of Value
The economic concept of value is not intrinsic in the commodity, good, or service to
which it is ascribed. Rather, it is created in the minds of the individuals who make up
the market. The interplay of relationships that create value is complex. Values change
when the factors that influence value change.
Typically, four interdependent economic factors create value:
• Utility
• Scarcity
• Desire
• Effective purchasing power
All four factors must be present for a property to have value. The four factors interact
in the marketplace to influence the relationship of supply and demand. A market’s
perception of value can affect real estate prices swiftly and significantly. For example,
when mortgage interest rates rise, the number of potential buyers who can afford the
higher rates declines, so effective demand declines.
Utility
Utility is the ability of a product to satisfy a human want, need, or desire. To have
value, properties must have utility to tenants, owner-investors, or owner-occupants.
In general, residential properties satisfy the need for shelter, and commercial prop-

erties house business activities. Both may have design features that enhance their
attractiveness. These features are called amenities. The value of amenities is related
to their desirability and utility to an owner-occupant or tenant-occupant. The value
of ownership may be measured from the prices paid for residences. The value of the
right to occupy space can be measured as the rent paid. The benefits derived from in-
come-producing properties can usually be measured in terms of rental revenue. The
influence of utility on value depends on the characteristics of the property. The utility,
or usefulness, of a property may relate to its size, design, location, and other specific
characteristics. Time-distance relationships clearly affect the value of property. These
different forms of utility can significantly influence property value.
The benefits of real property ownership are derived from the bundle of rights
that an owner possesses. Restrictions on ownership rights may limit benefits and,
therefore, lower the value of those rights. A property can only achieve its highest
value if it can legally perform its most useful function. Environmental regulations,
zoning regulations, deed restrictions, and other limitations on the rights of owner-
ship can enhance or detract from a property’s utility and value.
Scarcity
Scarcity is the present or anticipated supply of an item relative to the demand for it.
In general, if demand is constant, the scarcity of a commodity makes it more valu-
able. Land, for example, is still generally abundant. However, useful, desirable land
is relatively scarce and, therefore, has greater value. No asset, including real property,
can have value unless scarcity is coupled with utility. Air, which has a high level of
utility, has no definable economic value because it is abundant, but to a scuba diver
who is 100 feet underwater with a tank that is almost empty, air is extremely valu-
able. The question again becomes one of supply and demand. Because of scarcity,
many types of commercial land adjacent to a busy street with good access will com-
mand a higher price than land that is not next to a busy street. Commercial land buy-
ers seek out parcels near busy streets that have reasonably good access and visibility.
Some commercial land users, like car dealers, can accept parcels with good visibility
but inadequate access, but businesses such as drug stores, fast food restaurants, and
gas stations generally require good visibility and access. Corner lots of commercial
land—which are of limited supply and offer greater utility—often sell for much more
than lots that are not on a corner.
Desire
Desire is the wish of a user for an item to satisfy needs (e.g., shelter, clothing, food,
companionship) or individual wants beyond the essentials required to support life.
A desire for shelter, comfort, and sometimes prestige supports the development of a
variety of residential property types, from starter homes to mansions. Desire could
also include a business purpose such as the need for a place to sell or manufacture
products. This type of desire supports commercial real estate development.
Effective Purchasing Power

Effective purchasing power is the ability of an individual or group to participate in
a market—that is, to acquire goods and services with cash or its equivalent. A valid
opinion of the value of a property includes an accurate assessment of the market’s
ability to pay for the property.

Supply and Demand
The complex interaction of the four factors that create value is reflected in the basic eco-
nomic principle of supply and demand. The utility of a commodity, its scarcity or abun-
dance, the intensity of the human desire to acquire it, and the effective power to purchase
it all affect the supply of and demand for the commodity in any given situation.
Demand for a commodity is created by its utility and affordability. Demand is
also influenced by desire and the forces that create and stimulate desire. Although
human longing for things may be unlimited, desire is restrained by effective purchas-
ing power. Thus, the inability to buy expensive things affects demand.
Similarly, the supply of a commodity can be influenced by its utility and limited
by its scarcity. The availability of a commodity is affected by its desirability. Land is
a limited commodity, and the land in an area that is suitable for a specific use will
be in especially short supply if the perceived need for it is great. Sluggish purchas-
ing power tends to keep supply in check. If purchasing power expands, the supply
of a relatively fixed commodity will dwindle and create a market-driven demand to
increase the supply for which there is latent or pent-up demand.
Distinctions Among Price, Cost, and Value

Appraisal practice makes careful distinctions among the related terms price, cost,
and value. The term price refers to the amount a particular purchaser agrees (or has
agreed) to pay and a particular seller agrees (or has agreed) to accept under the cir-
cumstances surrounding their transaction. A price, once finalized, refers to a transac-
tion price and implies an exchange. The exchange can be temporary (as in a lease) or
permanent (as in a sale). But in all cases, price is a fact.
Some people use cost and value synonymously, but appraisal practice requires
more precise definitions. The term cost is used by appraisers in relation to production,
not exchange. Cost may be either an accomplished fact or an estimate.
The construction cost of components or of an entire building normally includes the
direct costs of labor and materials as well as indirect costs such as administrative fees,
professional fees, and financing costs. Development cost is the cost to create a prop-
erty, including the land, and bring it to an efficient operating state. Development cost
includes acquisition costs, actual expenditures, and the profit required to compensate
the developer or entrepreneur for the time and risk involved in creating the project.
Real estate-related expenditures for labor and capital are directly linked to the
price of goods and services in competitive markets. For example, the costs of roofing
materials, masonry, architectural plans, and rented scaffolding are determined by the
interaction of supply and demand in specific areas. Thus, they are subject to the influ-
ence of social, economic, governmental, and environmental forces.
Value can have many meanings in real estate appraisal. The applicable definition
depends on the context and usage. Value is commonly perceived as the anticipation
of future benefits. Because value changes over time, an appraisal reflects value at a
particular point in time. Because value is an economic
concept, the monetary worth of property, goods, or
services to buyers and sellers is an expression of value. The terms price, cost, and
In an appraiser’s identification of the objective of an value are used and defined
appraisal, the term value is not used alone. Rather, it carefully in appraisal practice.
is accompanied by some form of modifier. To avoid

confusion, appraisers do not use the word value alone.
The principles of anticipa- Instead they refer to market value, fair value, use value, in-
tion, change, supply and
demand, competition, and vestment value, assessed value, and other specific kinds of
substitution are fundamental value. Market value is the focus of most real property
to understanding the dynam- appraisal assignments.
ics of value.
Anticipation and Change

The human actions that collectively shape market activ-
ities reflect the pursuit of economic goals. The fundamental principles of anticipation
and change must be addressed to effectively analyze the many dynamic and interac-
tive factors that influence people’s attitudes and beliefs about value.
Anticipation
Value is created by the anticipation of benefits to be derived in the future. In real es-
tate markets, the current value of a property may not be based on its historical prices
or the cost of its creation. While these may provide indications of a property’s value,
the market participants’ perceptions of the benefits that acquisition of the property
will bring is the basis of a property’s current value.
The value of owner-occupied residential property is based primarily on expected
future advantages, amenities, and the opportunity
cost of ownership and occupancy. Prior to the prop-
All values are anticipations erty’s sale, the primary investment return is measured
of the future. in these amenities and the economic benefit of own-
—Justice Oliver Wendell ing rather than renting property, not in the receipt of
Holmes, Jr. income. The value of income-producing real estate is
based on the economic benefits (income and apprecia-
tion) it is expected to produce in the future. There-
fore, real property appraisers must be aware of local,
anticipation
regional, national, and international real estate trends
The perception that value is
created by the expectation that affect the perceptions of buyers and sellers and
of benefits to be derived in their expectations of the future. Historical data on a
the future. property or a market is relevant only insofar as it helps
interpret current market anticipations.
Change
The dynamic nature of the social, economic, governmental, and environmental forces
that influence real property value accounts for change. Although change is inevitable
and continuous, the process may be gradual and not easily discernible. In active
markets, change may occur rapidly. Abrupt changes may be precipitated by plant
or military base closures, tax law revisions, the start of new construction, or natural
disasters. The pervasiveness of change is evident in the real estate market, where the
social, economic, governmental, and environmental forces that affect real estate are in
constant transition. Changes in these forces influence the demand for and supply of
real estate and, therefore, individual property values. Appraisers attempt to identify
current and anticipated changes in the market that could affect current property
values, but, because change is not always predictable, opinions of value are said to be
valid only as of the specified date of valuation. An appraiser’s analyses and conclu-

sions reflect what the market anticipates, rather than
what the appraiser or the owner anticipates. change
Shifts in market preferences also provide evi- The result of the cause and
effect relationship among
dence of change. Real estate is not readily adaptable the forces that influence real
to new consumer preferences and thus often suffers property value.
obsolescence, i.e., an impairment of desirability and
usefulness. The physical, functional, and external
impairments observed in buildings as they age result
in depreciation, which is defined as a loss in the value of an improvement from any
cause. Depreciation may be seen as the difference between the cost to reproduce
or replace an improvement and its present value. In general, losses in the value of
improvements are caused by deterioration or obsolescence. Because obsolescence can
begin in the design phase and deterioration may start while a building or improve-
ment is still being constructed, the different types of deterioration and obsolescence
found in a property have unique implications in appraisal. (A detailed discussion of
deterioration and obsolescence is presented in Chapter 31.)
Supply and Demand, Substitution, Balance, and Externalities

The appraisal principles of supply and demand, substitution, balance, and externali-
ties can be applied to the unique physical and legal characteristics of a particular
parcel of real estate. When these basic economic principles are in proper accord, they
indicate highest and best use, which has great significance in real property appraisal.
(Highest and best use is discussed in detail in Chapters 17 and 18.)
Supply and Demand

In keeping with the principle of supply and demand, an increase in the supply of an item
or a decrease in the demand for an item tends to reduce its price (or value). The opposite
conditions produce an opposite effect. The relationship between supply and demand
may not be directly proportional, but the interaction of
these forces is fundamental to economic theory. The inter-
action of suppliers and demanders, whether sellers and
buyers or landlords and tenants, constitutes a market. supply and demand
Usually property values vary directly with changes In economic theory, the
principle that states that the
in demand and inversely with changes in supply. If price of a commodity, good,
properties for a particular use become more abundant or service varies directly, but
relative to demand, their value declines. By contrast, if not necessarily proportion-
properties become relatively more scarce (supply de- ately, with demand, and
clines relative to demand), the value of the properties inversely, but not necessarily
proportionately, with supply.
increases. The supply of and demand for commodities In a real estate appraisal
always tend to move toward equilibrium. context, the principle of sup-
Typically, more of an item will be supplied at a ply and demand states that
higher price and less at a lower price. Therefore, the the value of real property
supply of an item at a particular price, at a particular varies directly, but not neces-
sarily proportionately, with
time, and in a particular place indicates that item’s demand and inversely, but
relative scarcity, which is a basic factor of value. When not necessarily proportion-
demand for real estate in a particular market increases, ately, with supply.
property values rise and the quantity of new proper-

ties offered for sale generally increases. When the supply of the real estate declines,
property values again tend to rise. On the other hand, increases in the productivity
of labor, greater technological efficiency, improvements in capital goods, and more
capital goods per worker can all reduce development costs. A building boom set in
motion by the rising expectations of profit among developers may result in an over-
supply of properties.
Generally the quantity of space supplied for a given use is slow to adjust to
changes in price levels. The length of time needed to build new structures, the large
amount of capital required, and government regulations often hamper a supplier’s
ability to meet changes in the market. The quality of space, however, can change
more rapidly because suppliers can convert nonproductive space to alternative uses,
cure deferred maintenance, or reconfigure space into more desirable units.
Demand is the desire and ability to acquire goods and services, through purchase
or lease. Typically, less of an item will be demanded at a higher price, and more will
be demanded at a lower price. Because it is difficult to augment the supply of real
property for a specific use in a short time, values are strongly affected by current de-
mand. Demand, like supply, can be characterized in terms of both quantity and qual-
ity. For example, demand in a residential market may be measured by the number
of households in the market area and households seeking to reside in that market.
Demand is affected by household incomes, the size and characteristics of the house-
holds, and specific housing preferences. Demand that is supported by purchasing
power results in effective demand, which is the type of demand considered by the
market. Appraisers must interpret market behavior to ascertain the existing relation-
ship between the supply of and the demand for the type of property being appraised.
Competition between buyers or tenants represents the interactive efforts of two or
more potential buyers or tenants to make a purchase or secure a lease. Between sellers
or landlords, competition represents the interactive efforts of two or more potential
sellers or landlords to effect a sale or lease. Competition is fundamental to the dynam-
ics of supply and demand in a free enterprise, profit-maximizing economic system.
Buyers and sellers of real property operate in a competitive market setting. In es-
sence, each property competes with all other properties
suitable for the same use in a particular market seg-
effective demand ment and often with properties from other market seg-
The desire to buy coupled ments. For example, existing residential subdivisions
with the ability to pay. When compete with new subdivisions, and downtown retail
the term demand is used properties compete with suburban shopping centers.
in economics or real estate
analysis, effective demand is Over time, competitive market forces tend to reduce
usually presumed. unusually high profits. Profit encourages competition,
competition (among but excess profits tend to breed ruinous competition.
properties) For example, the first retail store to open in a new and
The level of productivity and expanding area may generate more profit than is con-
amenities or benefits of a sidered typical for that type of enterprise. If no barriers
characteristic of each prop- to entry exist, owners of similar retail enterprises will
erty considering the advanta-
geous or disadvantageous likely gravitate to the area to compete for the surplus
position of the property profits. Eventually there may not be enough business
relative to the competitors. to support all the retailers. A few stores may profit, but
others will fail. The effects of competition and market

trends on profit levels are especially evident to appraisers making income and occu-
pancy projections as part of the income capitalization approach to value. This pattern
of market activity is also evident in residential markets. The first developer may find
significant demand for finished houses. When too many other home builders enter
the market, the market can become overbuilt, and profits decline.
Substitution
The principle of substitution states that when several similar or commensurate com-
modities, goods, or services are available, the one with the lowest price attracts the
greatest demand and widest distribution. This principle assumes rational, prudent mar-
ket behavior with no undue cost due to delay. According to the principle of substitution,
a buyer will not pay more for one property than for another that is equally desirable.
Property values tend to be set by the cost of acquiring an equally desirable
substitute property. The principle of substitution recognizes that buyers and sellers
of real property have options, i.e., other properties are available for similar uses. The
substitution of one property for another may be considered in terms of use, structural
design, or earnings. The cost of acquisition may be viewed as the cost to purchase a
similar site and construct a building of equivalent utility, assuming no undue cost due
to delay. This is the basis of the cost approach. On the other hand, the cost of acquisi-
tion may be the price of acquiring an existing property of equal utility, again assum-
ing no undue cost due to delay. This is the basis of the sales comparison approach.
The principle of substitution is equally applicable to properties such as houses,
which are purchased for their amenity-producing attributes, and properties pur-
chased for their income-producing capabilities. The amenity-producing attributes of
residential properties may include excellence of design, quality of workmanship, or
superior construction materials. For an income-producing property, an equally desir-
able substitute might be an alternative investment property that produces equivalent
investment returns with equivalent risk. The limits of property prices, rents, and rates
tend to be set by the prevailing prices, rents, and rates of equally desirable substi-
tutes. The principle of substitution is fundamental to all three traditional approaches
to value—sales comparison, cost, and income capitalization.
Although the principle of substitution applies in most situations, sometimes the
characteristics of a product are perceived by the market to be unique. The demand
generated for such products may result in unique pricing. For example, a market may
not have ready substitutes for special-purpose properties like a historic residence, a
medical office building, or a high-tech manufacturing plant. In those situations, the
appraiser may have to research substitute properties in a broader market or employ
analytical techniques appropriate for limited-market properties.
Balance
The principle of balance holds that real property value is created and sustained when
contrasting, opposing, or interacting elements are in a state of equilibrium. This
principle applies to relationships among various property components as well as the
relationship between the costs of production and the property’s productivity. Land,
labor, capital, and entrepreneurial coordination are the agents of production, but for
most real property the critical combination is the land and improvements. Economic
balance is achieved when the combination of land and improvements is optimal.

The principle of balance governs the related prin-
The principles of balance, ciples of diminishing returns, contribution, surplus
decreasing marginal utility,
contribution, surplus produc- productivity, and conformity. The law of diminishing
tivity, and conformity explain returns holds that increments in the agents of produc-
how the integration of tion added to a parcel of property produce greater net
property components affects income up to a certain point. At this point—the point
property value. of decreasing or diminishing returns—any additional
expenditures will not produce a return commensurate
with the additional investment. When the point of
decreasing returns is reached, further increments in the
agents of production will cause productivity to decline proportionally.
The fertilization of farmland provides a simple example. Applying fertilizer to a
land parcel increases crop yield only up to a point. Beyond that point the additional
fertilizer will produce no further increase in the output of the acreage. The optimum
amount of fertilization is achieved when the yield resulting from the fertilizer equals
the appropriate expenditure on fertilizer. This is the point of balance.
As a further illustration, consider a developer who is deciding how many bed-
rooms to include in a dwelling being developed for sale in a residential market. The
typical dwelling in this residential market has three bedrooms. It may be uneconomic to
include a fourth bedroom if the cost to build it exceeds the value added to the property.
The principle of balance also applies to the relationship between a property and
its environment. A proper mix of various types and locations of land uses in an area
creates and sustains value. A residence near other residences has much more market
appeal than a residence next to a landfill.
The principle of balance and the principles of contribution, surplus productivity,
and conformity are interdependent and crucial in highest and best use analyses and
market value estimation. These concepts form the theoretical foundation for estimating
all forms of depreciation in the cost approach, making adjustments in the sales compari-
son approach, and calculating expected earnings in the income capitalization approach.
The principle of contribution states that the value of a particular component is
measured in terms of its contribution to the value of the whole property or as the
amount that its absence would detract from the value of the whole. The cost of an
item does not necessarily equal its value. A swimming pool that costs $30,000 to
install does not necessarily increase the value of a residential property by $30,000.
Rather, the pool’s dollar contribution to value is measured in terms of its benefit or
utility in the market. The swimming pool’s contribution to value may be
• Higher than its cost (if properties with swimming pools are in very high demand
in the market).
• Equal to its cost.
• Lower than its cost, though still contributing positively to value. This is the most
common situation, i.e., more than zero but less than its cost.
• No contribution to value. Adding a swimming pool could have no effect on the
value of that property in that market at that time.
• A negative contribution to value. The swimming pool may need to be removed at
an additional cost for the property to reach its highest and best use.

The contribution of the existing improvements may
increasing and decreasing
not be in proper balance with the total property. Espe- returns
cially in transitional areas, a property’s present use may The concept that successive
not use the land to its full potential. In other words, a increments of one or more
potential buyer may be more likely to base an invest- agents of production added
ment decision on the risk and reward associated with a to fixed amounts of the
future use of the property rather than the current use, other agents will enhance
income or value (in dollars,
which is called an interim use. Nevertheless, an interim
5
benefits, or amenities) at
use will continue until it is economically feasible to an increasing rate until a
absorb the costs of converting the property, either by maximum return is reached.
razing and replacing the existing improvements or by Beyond a certain point, each
rehabilitating them. The principle of contribution is additional unit will add less
income or value than the
also applicable in the assemblage of land parcels. The unit before it. Also called the
contributory value of property as part of an assemblage law of increasing returns or
may be greater than its market value alone. In other law of decreasing returns.
words, the value of the whole may be more or less than
the sum of the parts.
Surplus productivity is the net income to the land
remaining after the costs of the other agents of production have been paid. The clas-
sical economists of the eighteenth and nineteenth centuries identified the surplus as
land rent, which they understood to account for land value. Traditionally, the prin-
ciple of surplus productivity has provided the basis for the residual concept of land
returns and residual valuation techniques. (See Chapter 25.) The principles of surplus
productivity and residual returns to the land are useful in establishing the highest
and best use of land and in analyzing which option among alternative land use op-
tions will yield the highest value. Some contemporary economists argue that surplus
productivity should be ascribed to a different agent of production, i.e., the entrepre-
neurial coordination required to combine the land, labor, and capital into a complete
real estate product.
The principle of conformity holds that real property value is created and sus-
tained when the characteristics of a property conform to the demands of its market.
The styles and uses of the properties in a given area may conform for several reasons,
including economic pressures and the shared preferences of owners for certain types
of structures, amenities, and services. The imposition and enforcement of zoning
ordinances and plans by local governments to regulate land use may also contribute
to conformity. Standards of conformity set by the market are subject to change. Local
building codes and private restrictions, which tend to establish conformity in basic
property characteristics such as size, style, and design, are often difficult to change
and may hasten the pace of obsolescence.
A particular market also sets standards of conformity, especially in terms of price.
According to the principle of regression, the value of an overimproved property will
decline toward the value level of surrounding, conforming properties. Under the
principle of progression, the value of an underimproved property may increase to-
ward the prevailing market standard. Of course, there are exceptions to these princi-
ples. For example, the seasonal cottages found among the luxurious vacation homes
5. Interim uses are discussed in more detail in Chapters 17 and 18.

lining a popular recreational lake may exert no effect, either positive or negative, on
the value of one another because the market accepts the diversity, thereby mitigating
the principle of conformity.
Externalities
The principle of externalities states that factors external to a property can have either
a positive or negative effect on its value. Bridges and highways, police and fire
protection, and a host of other essential structures and services are generally posi-
tive externalities and are provided most efficiently through common purchase by
the government. Even so, these essential structures can have a negative effect on an
individual property, such as the case of a residence located adjacent to a busy high-
way or fire station. Negative externalities may also be observed when inconveniences
are imposed on property owners by the actions of others. As an example, a firm that
violated environmental law by releasing contaminants into a public waterway would
most likely affect neighboring properties, and, if the negligent firm went bankrupt,
the general community may need to address the cleanup costs.
Because it is physically immobile, real estate is affected by external influences
more strongly than most other economic goods, services, or commodities. Externali-
ties may refer to the use or physical attributes of properties located near the subject
property or to the economic conditions that affect the market in which the subject
property competes. For example, an increase in the purchasing power of the house-
holds that constitute the trade area for a retail facility will likely have a positive effect
on the sales potential of the property (i.e., its ability to produce income).
On a broad level, international economic conditions can influence real estate
values through externalities such as the availability of foreign capital or the effect of
increasing or decreasing foreign trade on the health of the national economy. In the
United States, the effects of foreign trade are particularly strong in states bordering
Mexico and on the West Coast, which have economies subject to shifts in trade vol-
ume with Latin American and Pacific Rim countries.
National fiscal policy also plays a vital role in the economy and, consequently, in
real estate markets. The Tax Reform Act of 1986 eliminated many of the tax advan-
tages of investing in income-producing property, changing the after-tax returns for
investors and then their before-tax return requirements. This change had a far-reach-
ing effect on the value of investment properties.
At the community and neighborhood levels, property values are affected by fac-
tors such as local laws, local government policies and administration, property taxes,
economic growth, and social attitudes. Different property value trends can be found
in communities in the same region and among neighborhoods in the same commu-
nity. Appraisers should be familiar with external events at all levels that can influence
property values.

The Valuation Process 4
The valuation process is a systematic procedure an appraiser follows to provide

answers to a client’s questions about real property value. It is a model that can be
adapted to a wide variety of questions that relate to value. It can also be used—per-
haps with some modification—to answer questions not directly related to value, as in
the case of review and other assignments.
The objective of most appraisal assignments is to develop an opinion of market
value. The valuation process contains all the steps appropriate for this type of assign-
ment. The model also provides the framework for developing an opinion of other
defined values.
In assignments to develop an opinion of market value, the ultimate goal of the
valuation process is a well-supported value conclusion that reflects all of the per-
tinent factors that influence the market value of the property being appraised. To
achieve this goal, an appraiser uses three different approaches to value.
1. In the cost approach, value is indicated by the current cost of reproducing or
replacing the improvements (including indirect costs and entrepreneurial incen-
tive), less depreciation, plus land value.
2. In the sales comparison approach, value is indicated by analysis of sales of compa-
rable properties appropriately adjusted for differences from the subject property.
3. In the income capitalization approach, value is indicated by the present value of
a property’s earning power, based on the capitalization of income.
Traditionally, specific appraisal techniques are applied within the three approaches
to derive indications of real property value. One or more approaches to value may be
used depending on which approaches are necessary to produce credible assignment
results, given the intended use.
The three approaches are interrelated.1 Each requires the gathering and analy-
sis of data that pertains to the property being appraised. Each approach is outlined
1. The sales comparison approach was once known as the “market approach.” However, all three approaches to value are “market” approaches in
that they rely on market data.
briefly in this chapter and discussed in detail in subsequent sections of this book.
From the approaches applied, the appraiser develops separate indications of value
for the property being appraised. To complete the valuation process, the appraiser in-
tegrates the information drawn from market research, data analysis, and the applica-
tion of the approaches to reach a value conclusion. This conclusion may be presented
as a single point estimate of value or, if the assignment permits, as a range within
which the value may fall (or as a relationship to a point referenced from a benchmark
amount). The effective integration of all the elements in the process depends on the
appraiser’s skill, experience, and judgment.
The components of the valuation process are shown in Figure 4.1.
Identification of the Appraisal Problem

The first step in the valuation process is the development of a clear understanding
of the problem to be solved. This sets the parameters for the assignment. To solve
any problem, the problem must first be identified, and only then can the appropriate
solution to the problem be determined. In appraisal practice, problem identification
logically precedes the scope of work determination.
Identification of the appraisal problem involves identifying each of the following:
• Client
• Intended use of the assignment results
• Intended users of the appraisal report in addition to the client
• Type of value and its definition
• Effective date of the opinions and conclusions
• Identification of the characteristics of the property that are relevant to the type
and definition of value and intended use of the appraisal (including its location,
the property rights to be valued, and other features)
• Assignment conditions, including extraordinary or special assumptions, hypo-
thetical conditions, laws and regulations, jurisdictional exceptions, and other
conditions that affect the scope of work
Before identifying the initial characteristics of the property and any assignment
conditions that are relevant to the purpose of the assignment, an appraiser must
identify the client, intended users, intended use, the type and definition of value, and
the effective date of the opinion of value. Once the appraisal problem has been identi-
fied, the appraiser can determine the appropriate scope of work for the assignment.
Scope of Work Determination

Scope of work is one of the most critical decisions an appraiser will make in perform-
ing an assignment. (The topic is discussed in more detail in Chapter 8.2) Solving an
appraisal problem involves three steps:
1. Identify the appraisal problem
2. Determine the scope of work necessary to solve the client’s problem
3. Apply the scope of work necessary to solve the problem
2. Scope of work is also discussed more fully in Stephanie Coleman, Scope of Work, 2nd ed. (Chicago: Appraisal Institute, 2016).

Figure 4.1 The Components of the Valuation Process
Identification of the Problem
Identify the Identify the Identify the Identify the Identify the relevant Identify any
client and intended use type and definition effective date characteristics assignment
intended users of value of the opinion of the property conditions
Scope of Work Determination
Data Collection and Property Description
Market Area Data Subject Property Data Comparable Property Data

General characteristics of Subject characteristics of Sales, listings, offers,
region, city, and neighborhood land use and improvements, vacancies, cost and depreciation,
personal property, business income and expenses,
assets, etc. capitalization rates, etc.
Data Analysis
Market Analysis Highest and Best Use Analysis

Demand studies Land as though vacant
Supply studies Ideal improvement
Marketability studies Property as improved
Land Value Opinion
Application of the Approaches to Value
Sales Comparison Approach Income Capitalization Approach Cost Approach
Reconciliation of Value Indications and Final Opinion of Value
Report of Defined Value

None of the three steps can be omitted, and each must be performed in order.
Scope of work encompasses all development aspects of the valuation process,
including
• which approaches to value will be used,
• how much data is to be gathered, from what sources, from which geographic
area, and over what time period,
• the extent of the data verification process,
• and the extent of property inspection, if any.
The scope of work decision is acceptable when it allows the appraiser to arrive at
credible assignment results and is consistent with the expectations of intended users
of similar assignments and the work that would be performed by the appraiser’s
peers in a similar assignment.
Planning the Appraisal

To complete an assignment efficiently, each step in the valuation process should be
planned and scheduled. Time requirements will vary with the amount and complex-
ity of the work. Some assignments may be completed in less than a day. For more
complex appraisal problems, weeks or months may be spent gathering, analyzing,
and applying all pertinent data.
Some assignments can be performed by one appraiser, while others require the
assistance of other staff members or appraisal specialists. Sometimes the assistance
of specialists in other fields is needed. For example, in valuing a proposed building
renovation, an appraiser’s findings may be augmented by the professional opinion
of a building contractor on renovation costs. Recognizing when work can or must be
delegated improves efficiency and enhances accuracy, but appraisers should also be
aware of the responsibilities inherent in the use of reports prepared by others. (These
types of concerns are addressed in the Appraisal Institute’s Guide Note 4 and Stan-
dards Rule 2-3 of the Uniform Standards of Professional Appraisal Practice.) If an ap-
praiser signs any part of a report, that individual must sign the certification and thus
will have to take full responsibility for the entire assignment. With a comprehensive
view of the assignment, an appraiser can recognize the type and volume of work to
be done and schedule and delegate that work properly.
An appraiser’s work plan usually includes an outline of the proposed appraisal re-
port. The major parts of the report are delineated, and the data and procedures involved
in each section are noted. Using this outline, data can be assembled logically and the
appropriate amount of time can be allocated to each step in the valuation process.
Data Collection and Property Description

Following the initial analysis (i.e., the identification of the appraisal problem and
determination of the scope of work), the appraiser gathers data on the market area,
the subject property, and comparable properties in the market. The data needed by
appraisers can be divided into general data and specific data.
General data includes information about trends in the social, economic, govern-
mental, and environmental forces that affect property value in the defined market
area. A trend is a momentum or tendency in a general direction brought about by a
series of interrelated changes. Trends such as population shifts, declining office build-

ing occupancy rates, and increased housing starts in a market area are identified by
analyzing general data. General data can contribute significantly to an appraiser’s
understanding of the marketplace.
Specific data relates to the property being appraised and to comparable proper-
ties. This data includes legal, physical, locational, cost, and income and expense in-
formation about the properties and the details of comparable sales. Financial arrange-
ments that could affect selling prices are also considered.
Data on comparable properties can be either general data that an appraiser has
on file or specific data that must be gathered for a particular assignment. More often,
comparable property data is specific supply and demand data that relates to the com-
petitive position of properties similar to the subject. Supply data includes inventories
of existing and proposed competitive properties as well as vacancy rates. Demand
data may relate to absorption, population, income, employment, and potential prop-
erty users. From this data an estimate of future demand for the present or prospective
use or uses of the subject property is developed.
The amount and type of data collected for an appraisal depends on the ap-
proaches used to develop an opinion of value and on the defined scope of work. In
a given valuation assignment, more than one approach to value is often appropriate
for the development of a value opinion. Depending on the problem or problems to be
addressed, one approach may be given greater emphasis in deriving the final opin-
ion of value. In conducting a particular assignment, the appraiser’s judgment and
experience and the quantity and quality of data available for analysis may determine
which approach or approaches are used. In some assignments, a valuation technique
may be appropriate but not necessary for credible assignment results. In other assign-
ments, the same technique may be deemed necessary (indeed, critical) for the assign-
ment results to be credible.
The data collected should be as meaningful and relevant as possible. All pertinent
value influences, facts, and conclusions about trends should be clearly indicated in the
report and related specifically to the property being appraised. Because the data select-
ed forms the basis for the appraiser’s judgments, a thorough explanation of the signifi-
cance of the data reported ensures that the reader will understand these judgments.
Irrelevant data should be excluded because the inclusion of that data may detract
from the credibility of the appraiser’s analyses and conclusions. Recent prior sales
of the subject property are almost always relevant, as are listings, options, or agree-
ments of sale current as of the date of value. It is not sufficient to simply report the
subject property’s sales history. Itemizing the sales or other agreements is only a start.
The identification and analysis of current listings and options should connect to the
appraiser’s analysis of the subject property. This information must be analyzed and
compared to the value opinion, and a discussion of this analysis must generally be
included in the appraisal report.
Data Analysis
Once the appropriate data has been collected and reviewed for accuracy, an appraiser
begins the process of data analysis, which has two components: (1) market analy-
sis and (2) highest and best use analysis. Even the simplest appraisal assignments
involving the development of an opinion of market value must be based on a solid
understanding of prevalent market conditions and the highest and best use of the

real estate. The two forms of analysis are related. In fact, an appraiser’s investigation
into trends affecting the economic base of the market area leads directly to the deter-
mination of highest and best use.
Market Analysis
Market analysis is a study of market conditions for a specific type of property. A
description of prevalent market conditions helps an intended user of an appraisal
report understand the motivations of participants in the market for the subject prop-
erty. Broad market conditions provide the background for local and neighborhood
market influences that have direct bearing on the value of the subject property.
Market analysis, which is discussed in detail in
Chapters 15 and 16, serves two important functions.
Analyses of market condi- First, it provides a background against which local de-
tions and highest and best velopments are considered. Second, a knowledge of the
use are crucial to the valua-
tion process when a market broad changes that affect supply and demand gives an
value opinion is the objective appraiser an indication of how values change over time.
of the assignment. The data and conclusions generated through
market analysis are essential components in other por-
tions of the valuation process. Market analysis yields
information needed for each of the three traditional
approaches to value. In the cost approach, market analysis provides the basis for
adjusting the cost of the subject property for depreciation, i.e., physical deterioration
and functional and external obsolescence. In the income capitalization approach, all
the necessary income, expense, and rate data is evaluated in light of the market forces
of supply and demand. In the sales comparison approach, the conclusions of market
analysis are used to delineate the market and thereby identify comparable properties
and the marketable amenities within those comparable properties.
The extent of market analysis and the level of detail appropriate in the report
depend on the appraisal problem under examination. When the appraisal assignment
is complex—e.g., an analysis of the feasibility of a proposed development—a more
detailed market analysis will be required. Regardless of the assignment’s complexity,
the logic of the market analysis should be communicated clearly to the reader in the
appraisal report. The level of detail provided may depend on the needs of the client
and intended users of the report and on the intended use of the assignment.
Highest and Best Use Analysis

Whenever a market value opinion is developed, highest and best use analysis is
necessary. Through highest and best use analysis, an appraiser interprets the market
forces that affect the subject property and identifies the use or uses on which the final
opinion of value is based. (Highest and best use analysis is discussed in detail in
Chapters 17 and 18.) If highest and best use is not adequately addressed, appraisers
may inappropriately analyze the property being appraised.
When an assignment objective is to develop an opinion of market value, the ap-
praiser must address the question of the highest and best use for whatever is being
valued. In valuing an improved property, the appraiser must address the question of
the highest and best use as currently improved. In valuing a vacant site, the appraiser
must address highest and best use as though vacant. In valuing a site as if vacant (for

example, in applying the cost approach to an improved property), an appraiser must
address the question of the highest and best use as if vacant.
Analyzing the highest and best use of the land as though vacant helps the ap-
praiser identify comparable properties. Whenever possible, the property being ap-
praised should be compared with similar properties that have been sold recently in
the same market. Potentially comparable properties that do not have the same high-
est and best use are usually eliminated from further analysis. Estimating the land’s
highest and best use as though vacant is a necessary part of deriving an opinion of
land value.
Land Value Opinion

Appraisers often develop an opinion of land value separately, even when valuing
properties with extensive building improvements. Land value and building value
may change at different rates over time. Improvements are almost always subject
to depreciation with age, while land value is reported as of the date of valuation
without any consideration of depreciation. While land value may fluctuate over time,
land itself does not depreciate.
Developing an opinion of land value can be considered a separate step in the
valuation model or an essential technique for applying certain approaches to value,
depending on the defined appraisal problem and on the highest and best use analysis.
The relationship between highest and best use and land value3 may indicate whether
an existing use is the highest and best use of the land. The valuation of land often is
required in appraisals in which an opinion of market value is developed because all
market value appraisals require highest and best use analysis and that process in turn
requires comparing the land value and the value of the improved property.
An appraiser can use several techniques to obtain an indication of land value:
• Sales comparison
• Extraction
• Allocation
• Subdivision development
• Land residual
• Ground rent capitalization
The most common way to develop an opinion of land value is by sales comparison.
When few sales are available, however, or when the value indications produced
through sales comparison need additional support, procedures like extraction or
allocation may be applied. The other methods of land valuation, which all involve
income capitalization techniques, are subject to more limitations. They are gener-
ally used only to support the results of other valuation methods. The subdivision
development technique is a specialized valuation method useful in specific land use
situations.4 The land residual technique is used more often in highest and best use
analysis to test the feasibility of various uses than to estimate land value as part of
3. Appraisers distinguish between land (the earth’s surface, both land and water, and anything that is attached to it, whether by the course of nature
or by human hands) and a site (land that is improved so that it is ready to be used for a specific purpose). The distinctions between the two terms
are discussed more fully in Chapter 12.
4. The valuation of subdivisions is discussed more fully in Don M. Emerson, Jr., Subdivision Valuation, 2nd ed. (Chicago: Appraisal Institute, 2017).

one of the traditional approaches to value. Ground rent capitalization can be used
when land rents and land capitalization rates are readily available. (These land valua-
tion techniques are discussed in detail in Chapter 19.)

The valuation process is applied to develop a credible opinion of a defined value
based on an analysis of pertinent general and specific data. One or more of the three
approaches to value are used in deriving all opinions of value. The approaches
employed depend on the type of property, the intended use of the appraisal, and the
quality and quantity of data available for analysis. All three approaches are applica-
ble to many appraisal problems, but one or more of the approaches may have greater
significance in a given assignment.
Sales Comparison Approach

The sales comparison approach is most useful when a number of similar properties
have recently been sold or are currently for sale in the subject property’s market. Us-
ing this approach, an appraiser produces a value indication by comparing the subject
property with similar (i.e., comparable) properties. The sale prices of the properties
that are judged to be most comparable tend to indicate a range in which the value
indication for the subject property will fall.
Income Capitalization Approach

In the income capitalization approach, the present value of the anticipated future
benefits of property ownership is measured. Income capitalization converts periodic
future income expectations into a lump-sum capital amount. The future income ex-
pectations include both a property’s income and resale value. There are two methods
of income capitalization: (1) direct capitalization and (2) yield capitalization. In direct
capitalization, the relationship between one year’s income and value is reflected in
either a capitalization rate or an income multiplier. In yield capitalization, several
years’ income and a reversionary value, if any, at the end of a designated period are
forecasted and converted to present value using a yield rate. The most common ap-
plication of yield capitalization is discounted cash flow analysis. Given the significant
differences in how and when properties generate income, there are many variations
of both direct and yield capitalization procedures, which are addressed in Chapter 22.
Like the sales comparison and cost approaches, the income capitalization ap-
proach requires extensive market research. Data collection and analysis for this
approach are conducted against a background of supply and demand relationships,
which provide information about trends and market anticipation.
Cost Approach
The cost approach is based on the understanding that market participants relate
value to cost. In the cost approach, the value of a property is derived by adding the
appraiser’s opinion of the value of the land to an estimated current cost of construct-
ing a reproduction or replacement for the improvements and then subtracting the
amount of depreciation (i.e., deterioration and obsolescence) in the structures from all
causes. This approach is particularly useful in valuing new or nearly new improve-
ments and properties that are not frequently exchanged in the market. Cost approach

techniques can also be employed to derive information needed in the sales compari-
son and income capitalization approaches to value, such as cost-related adjustments
to account for specific building features and cost-to-cure adjustments to address
deferred maintenance.
final reconciliation
Final Reconciliation of Value Indications The last phase in the devel-
The final analytical step in the valuation process is the opment of a value opinion
reconciliation of the value indications derived into a in which two or more value
value conclusion. Reconciliation occurs within each indications derived from
market data are resolved
approach to value, but the final reconciliation occurs into a final value opinion.
at the end of the valuation process. The value conclu-
sion can be expressed as a single number, as a range
of numbers, or as a number greater than or less than a
specified benchmark amount. The nature of reconciliation depends on the appraisal
problem, the approaches that have been used, and the reliability and adequacy of the
data used.
When all three approaches have been used, the appraiser examines the three
separate indications and considers the relative reliability and applicability of each
approach (i.e., the strengths and weaknesses of each approach). In the reconcilia-
tion section of the report, the appraiser can explain variations among the indications
produced by the different approaches and account for differences between the value
conclusions and methods applied.
final opinion of value

Report of Defined Value The opinion of value that is
An appraisal report is the expression of the appraiser’s derived from the final reconcil-
work, and it is what the client sees as the culmination iation of value indications and
of the appraiser’s research and analysis. The prepara- stated in the appraisal report;
may be expressed as a single
tion and delivery of the appraisal report is generally point, as a range, or in relation
the last step in the valuation process, although many to a benchmark amount.
appraisers write their report during the development
process. The report may be communicated to the client
in writing or orally. Chapter 33 describes the require-
ments for appraisal reports and the circumstances under which they are prepared
and submitted.
The report of the value opinion or conclusion addresses the data analyzed, the
methods applied, and the reasoning that led to the value conclusion and does so in
a manner that enables the intended users to properly understand the appraiser’s
findings and conclusions. The objective of the appraisal report is to communicate the
valuation process with sufficient supporting evidence and logic to ensure that the as-
signment results are credible for the intended use.

Elements of the Assignment 5
In the first step of the valuation process, an appraiser identifies all the elements that
are relevant to the assignment:
• The client
• The intended users of the report
• The intended use of the report
• The type and definition of value (with source)
• The effective date of the opinion of value
• The relevant characteristics of the property
• Any assignment conditions such as extraordinary assumptions or hypothetical
conditions
The process of identifying the appraisal problem that was discussed in the previous
chapter is built on the combination of these assignment elements. If one of those as-
signment element changes, a different appraisal problem is created.
This chapter examines each of the assignment elements.The following chapters
in this section of the textbook delve deeper into two of the more complex elements:
(1) the type and definition of value and (2) the property rights being appraised in the
assignment.
Client
In valuation standards, the term client has a special meaning that is different from the
way the term is used in other disciplines. For example, in law, a client is the paying
party, which is not true with the definition of the term in appraisal practice. In an
appraisal, the client is the party (or parties) who engages the appraiser. The client
can be one person (such as an individual investor), one entity (such as a bank), or a
number of people or entities acting together. The client is always considered to be an
intended user—another classification specific to appraisal practice—even in cases in
which the client does not actually use the appraisal, such as when a client engages
an appraiser on behalf of another party. In assignments involving appraisal manage-
ment companies, the appraisal management company may act as an agent of a lender
and engage the appraiser, but the lender is the client.
Intended Users
Intended users are those who an appraiser intends will use the appraisal or review re-
port. In other words, appraisers acknowledge at the outset of the assignment that they
are developing their expert opinions for the use of the intended users they identify.
Although the client provides information about the parties who may be intended us-
ers, ultimately it is the appraiser who decides who they are. This is an important point
to be clear about: The client does not tell the appraiser who the intended users will be.
Rather, the client tells the appraiser who the client needs the report to be speaking to,
and given that information, the appraiser identifies the intended user or users.
It is important to identify intended users because an appraiser’s primary respon-
sibility regarding the use of the report’s opinions and conclusions is to those users.
Intended users are those parties to whom an appraiser is responsible for communi-
cating the findings in a clear and understandable manner. They are the audience.
It is important to understand that parties who receive, or who might receive, a
copy of the report are not automatically intended users. A party becomes an intended
user only because the appraiser identifies that party as such. Just because an ap-
praiser knows that a party will receive a copy of the report does not mean that the
appraiser is required to identify that party as an intended user. For example, just be-
cause the borrower will receive a copy of the report does not mean that the borrower
must be an intended user. And just because the “other side” in a litigation matter will
receive a copy of the report does not mean that this “other side” must be named as an
intended user.
Intended Use
Intended use is the valuer’s understanding of why the client and other intended us-
ers (if any) need the service. It is the use (or uses) to which the appraiser intends the
opinions and conclusions to be put. Some possible intended uses relate to:
• Financing
• Litigation support
• Condemnation
• Divorce settlements
• Buy/sell decisions
• Tax reporting
• Portfolio evaluation
• Arbitration
• Partnership buyouts
• Estate planning
• Charitable donations
• Valuations for financial reporting
• Other scenarios

Intended use is the most important factor in determining the appropriate scope of
work. It is the key driver in making that decision.
Appraisers have not traditionally been in the habit of asking a client why when
asked to provide an appraisal or review. Yet this is a critical question to ask because,
without answering that question, an appraiser cannot begin to make the appropriate
scope of work determination.
Type of Value and Its Definition

The type of value (market value, investment value, use value, or other) appropriate
for a specific assignment depends on the nature of the appraisal problem. That is,
what type of value does the client need to know about—market value, use value, or
some other type of value? Furthermore, the definition of the type of value used in an
assignment may depend on the intended use and user. As with the other assignment
elements, the type of value and its definition are identified by the appraiser based on
communication with the client at the time of the assignment.
For many real estate appraisals, the type of value being investigated is market
value. Note that clients, intended users, controlling jurisdictions, and the users of
appraisal services might define market value differently, so a clear statement of the
definition of the type of value being appraised (with source) helps the intended user
of the appraisal better understand the appraiser’s conclusions. (Identifying the type
of value and its definition are discussed in Chapter 6.)
Effective Date of the Value Opinion

The appraiser’s value opinions and conclusions relate to a specific point in time.
Given the client’s needs and the nature of the assignment, the appraiser must iden-
tify the exact date that the value opinion would be in effect. The effective date of the
opinion of value—sometimes called simply the date of value—can be a current date, a
retrospective (historical) date, or a prospective (future) date. For a current appraisal,
the effective date is often the date of inspection, if an inspection was included in the
appraiser’s scope of work.
The date of the value opinion (i.e., the effective date) should not be confused
with the date of the appraisal report, which is the date the report is transmitted to the
client. For most appraisal assignments, the effective date and the date of the appraisal
report will differ. The effective date of the appraisal refers to the point in time as of
which the analyses and conclusions are relevant, not the date on which the report is
delivered to the client.
Relevant Property Characteristics

The subject of an appraisal, i.e., what is being appraised, is an interest in an asset.
The interest may be a fee simple, leased fee, leasehold, or other type of interest. In the
case of a real property appraisal, the asset is the real estate. The analysis of the subject
property must account for the location and the physical, economic, and legal attri-
butes that affect the property’s value.
Some of the most important characteristics relating to value include
• The real property rights being appraised, i.e., “what is to be valued” (see Chapter 7)

• Location (see Chapters 11 and 12)
• Other physical characteristics such as size, layout, and quality of construction
(see Chapter 13)
• Economic characteristics such as rent levels and financing terms (see Chapter 10)
• Legal characteristics such as land use and zoning restrictions
Some of the relevant information will be provided by the client, and some will
be researched by the appraiser through interviews with property owners and market
participants, firsthand observation of the subject property, and other activities. Public
records are an obvious source of data on certain property characteristics. A complete
legal description is commonly used to identify a subject property, although other in-
formation can be useful as well such as a simple street address or an annotated map.
Many local governments have digital GIS mapping that appraisers can access.
In some cases, “what is to be valued”—particularly the interest to be appraised
and the definition of that interest—is dictated by applicable law or regulation. Ap-
praisers are responsible for knowing which laws or regulations apply and for com-
plying with those laws and regulations. “What is to be valued” affects the market
analysis, highest best use analysis, and application of the approaches to value.
Valuation Premises
In many appraisal assignments, it is not adequate to simply state or define the type of value being sought,
e.g., market value, use value, investment value, or disposition value. It is also necessary to fully describe the
valuation premises, which are the circumstances in which the hypothetical sale of a property is assumed to
take place. Examples of valuation premises include
• In subdivision appraisals, the bulk sale, gross retail proceeds, or aggregate of the retail sales premise
• For proposed project valuation, the current value, the prospective value on the anticipated completion
date (special assumption), the prospective value on the anticipated occupancy stabilization date (special
assumption), the value as if complete on the current date (hypothetical condition), and the value as if
complete and stabilized on the current date (hypothetical condition)
• For condemnation valuation, value before the taking under the hypothetical condition that the project had
not been announced, value after the taking under the hypothetical condition that the public project has
been completed, and value after the taking under the extraordinary assumption that the public project will
be constructed according to the condemnor’s plans
• For valuation for mortgage lending purposes, FIRREA’s “as is” valuation premise
Assignment Conditions
Almost all appraisal assignments are subject to some conditions that affect the scope
of work and must be communicated to the client to put the appraiser’s analysis in the
proper context. Assignment conditions include
• General assumptions
• Special (or “extraordinary”) assumptions
• Hypothetical conditions
• Laws and regulations
• Jurisdictional exceptions
• Other conditions that affect the scope of work for an assignment

Exposure Time
The concept of exposure time is an important assignment condition for appraisers to understand. The Dic-
tionary of Real Estate Appraisal, 6th edition, defines exposure time as follows:
The estimated length of time that the property interest being appraised would have been offered on the market prior
to the hypothetical consummation of a sale at market value on the effective date of the appraisal; a retrospective
opinion based on an analysis of past events assuming a competitive and open market.
Guide Note 14 of the Standards of Professional Practice of the Appraisal Institute: Concept of Exposure Time
notes that exposure time is not an opinion of the appraiser when it is specified by the client. Rather, the
exposure time is a condition of the assignment. The guide note further points out that the definition of dispo-
sition value includes the idea of “future exposure time,” which is often interpreted as a contradiction in terms.
Suppose an appraiser is developing an opinion of value subject to the condition that a sale would occur
within, say, five months from now as defined by the client. The appraisal assignment would be a prospec-
tive valuation, and the exposure time would be in the future relative to the date of the appraisal report. The
opinion of value is in the future relative to the date of the report but still predates the effective date of value
as described in the definition of exposure time.
Note that appraisers must not permit assignment conditions to limit the scope of
work to such an extent that the assignment results are not credible in the context
of the intended use. General assumptions and applicable laws and regulations are
generally straightforward.1 Special or extraordinary assumptions, hypothetical condi-
tions, and jurisdictional exceptions—which are typically treated as separate compo-
nents of appraisal reports—are discussed in detail below.
An appraiser might not be able to identify special assumptions and hypothetical
conditions that affect an appraisal until the analysis has actually begun. However,
an effort should be made to identify possible (or probable) special assumptions and
hypothetical conditions affecting the assignment during the initial communication
with the client.
Extraordinary assumption and hypothetical condition are terms that appear in
USPAP, but those valuation standards do not require these labels. An extraordinary
assumption or hypothetical condition may be identified in other ways (e.g., as a “spe-
cial condition”) as long as the substitute label is not misleading.
Any special or extraordinary assumption or hypothetical condition should be com-
municated to the client in a clear and conspicuous manner, along with a statement relat-
ing how the use of that assignment condition might have affected the assignment results.
Handling special assumptions and hypothetical conditions in a prominent manner in
appraisal reports is imperative because they can significantly affect an appraisal.
Special or Extraordinary Assumptions

A special or extraordinary assumption is something that is believed to be true on the
effective date of the appraisal for the sake of the appraisal but that may or may not
in fact be true as of the effective date of the appraisal. Unlike general assumptions,
which often apply to many appraisal assignments (and are sometimes treated as
boilerplate), special assumptions are specific to the assignment at hand. An appraisal
assignment may be subject to more than one special assumption.
1. Examples of general assumptions that are often used in appraisal assignments can be found in the sample engagement letters that are available
to Appraisal Institute professionals at www.appraisalinstitute.org.

The decision to base an appraisal on a special as-
In the Standards of Valuation sumption must be reasonable. The use of the special
Practice, the term special
assumption is used to assumption must be appropriate for the intended use
describe the same concept as of the appraisal. Furthermore, a special assumption
extraordinary assumption in must be clearly described in the appraisal report so that
the Uniform Standards of Pro- the intended users are not misled.
fessional Appraisal Practice. As an example of the appropriate use of a special
assumption, consider a property located in an old
industrial district where several nearby sites have been
identified with soil contamination from past manufac-
turing operations. There is no evidence that the site of the subject property has soil
contamination, and there has been no recent professional testing of the soil. There-
fore, the potential for soil contamination is an unknown condition for this property
on the effective date of value. In this assignment, the appraiser would be able to
analyze the land as if not contaminated using a special assumption.
If a special assumption ends up not being true, the results of the assignment
might be affected. Suppose now that the soil at the site described above is indeed con-
taminated. Under the special assumption that the site was free from contamination,
the appraiser would not have considered the cost to remediate any contamination. If,
after learning of the soil contamination, the client wanted an appraisal that accounted
for the existence of the contamination, the appraiser and the client would need to
agree on a new appraisal assignment that is not subject to the special assumption.
Hypothetical Conditions
In contrast to an extraordinary assumption, which may or may not be true, a hy-
pothetical condition—according to professional valuation standards such as the
Uniform Standards of Professional Appraisal Practice (USPAP) and the Standards
of Valuation Practice (SVP)—is something that is known to be contrary to fact as of
the effective date of the appraisal but that is taken to be true for the purposes of the
appraisal.2 For example, if a client wanted to know the value of a proposed develop-
ment as if it were complete at the current time, the appraisal assignment could be
performed using a value premise subject to the hypothetical condition that the nonex-
istent improvements were already in place and ready for use as proposed. Returning
to the example of the property located in an old industrial area, the appraiser would
use a value premise subject to a hypothetical condition if it was already known that
the property was affected by soil contamination but the appraiser was developing an
opinion of the value for the property as if it were not affected by that contamination.
Such a value might be sought to determine the feasibility of cleanup options.
Describing an opinion of value developed subject to a hypothetical condition as a
“hypothetical value” is a misnomer. The value itself is not hypothetical. As described
earlier in this chapter, the type and definition of value are identified on their own as
a distinct portion of the seven significant elements of the assignment, separately from
the determination of assignment conditions such as a hypothetical condition.
2. International Valuation Standards 2017 defines a special assumption similarly: “Where assumed facts differ from those existing at the date of
valuation, it is referred to as a ‘special assumption’.” (p. 27) Note that although the IVS and the Standards of Valuation Practice both use the
term special assumption, the meanings of the terms are not the same.

Jurisdictional Exceptions
Jurisdictional exceptions are rare but may affect an appraisal assignment when a
relevant law or regulation precludes compliance with the relevant professional valua-
tion standards. The requirements of federal, state, or local laws and regulations, such
as the Uniform Appraisal Standards for Federal Land Acquisitions, may preclude an
appraiser from complying with a part or parts of a set of professional valuation stan-
dards, such as the Uniform Standards of Professional Appraisal Practice. Only the
part or parts of the professional valuation standards that contradict the superseding
regulation are affected by the jurisdictional exception. The balance of the professional
standards remains in force.
Instructions from a client or an attorney alone would not create a jurisdictional
exception. Also, a jurisdictional exception must be an explicit exception to profes-
sional valuation standards. If a governmental regulation prescribes a particular
methodology for a specific situation but valuation standards do not discuss specific
methodologies for that type of situation, a jurisdictional exception is not appropriate-
ly invoked. Rather, the prescribed methodology is likely a recognized technique used
in appraisals in which the regulation is relevant, and an appraiser needs to use all the
appraisal techniques that would be applied by the appraiser’s peers and would result
in a credible appraisal for the intended use. In this case, the regulation adds to, rather
than subtracts from, the requirements of the professional valuation standards.
Because of their potential for affecting the development and results of an appraisal,
jurisdictional exceptions need to be identified at the beginning of an assignment rather
than after the fact. The appraisal report must disclose the part or parts of the valuation
standards that are voided by the law or regulation, and the appraisal report must cite
the law or regulation that precludes compliance with the valuation standards.

Identifying the Type of Value 6
and Its Definition
The type of value and its definition constitute important assignment elements that
must be determined as part of problem identification, i.e., the first step of the valua-
tion process. The type of value—and the specifications set out for it in its definition—
to a large degree dictate the nature of the data collected and the analyses performed
in the remaining steps of the valuation process. In any appraisal assignment in which
an opinion of value is a component of the scope of work, the type of value and its
specific definition are established by the appraiser based on communication with the
client at the time of engagement.
The definition of value typically has precise wording that is cited from an author-
itative source. The source may vary depending on the client and intended user. For
example, the lending industry has a specific definition of market value established by
federal regulation. A litigation valuation assignment may have a different definition
of market value established by state law. It is imperative that appraisers describe the
type of value and specify certain conditions that must be met for assignment results
to be credible and meaningful. In an appraisal report, the definition of value provides
the client with a formal explanation of the type of value being developed and thus
the objective of the appraisal. In fact, professional valuation standards require that the
definition of value being used in an assignment be included in an appraisal report.1
In appraisal practice, the use of the term value alone is often incomplete and is a
potentially misleading description of an opinion of the relative worth of an asset. In
an appraisal, the term value is always accompanied by a modifier, e.g., market value,
investment value, insurable value. Appraisers typically refer to a particular type of
value rather than use the word value on its own. The different value types clarify
whose opinion is relevant, under what specific circumstances, or for what purpose.
For example, market value is the opinion of a “market” collectively under specific
conditions set forth in the relevant definition relating to the relationship, knowledge,
and motivation of the parties, the terms of sale, and the conditions of sale.
1. Note that under USPAP rules for a restricted report, the appraisal report only has to state the type of value and cite the source. In other words,
the definition itself does not have to be in the report.
Market Value
The concept of market value is of paramount importance to real estate communities.
Vast sums of debt and equity capital are committed each year to real estate investments
and mortgage loans that are based on opinions of market value. Real estate taxation,
litigation, and legislation also reflect an ongoing, active concern with market value
issues. In virtually every aspect of the real estate industry and its regulation at local,
state, and federal levels, market value considerations are essential to economic stability.
A number of different definitions of market value can be found in a variety of
sources, including appraisal texts, real estate dictionaries, professional valuation
standards, federal and state regulations, laws, and court decisions. Despite differing
opinions on individual aspects of the market value definition, it is generally agreed
that market value results from the collective value judgments of market participants.
An opinion of market value is based on objective observation of the collective actions
of the market. Because the standard measure of these activities is usually cash, the
increases or diminutions in the sale price caused by financing and other terms of sale
are measured against an all-cash value.
The definition that follows represents the concept of value in exchange, and it
incorporates the concepts that are most widely accepted, such as willing, able, and
knowledgeable buyers and sellers who act prudently as of a specific date, with three
possible bases: (1) all cash, (2) terms equivalent to cash, or (3) other precisely revealed
terms. The definition also requires variation from the all-cash market value to be
quantified in terms of cash or cash equivalency.
Market Value
The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other
precisely revealed terms, for which the specified property rights should sell after reasonable
exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and
seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is
under undue duress.
Some appraisers cite this definition verbatim in their appraisal reports and state sepa-
rately that the value is stated in cash, in terms equivalent to cash, or in other terms.
Other appraisers reword relevant phrases in the value definition—e.g., they might
substitute “in cash” with “in terms arithmetically equivalent to cash” or “in terms
precisely revealed below” as appropriate.
The definition of market value developed by the
Market value is the major International Valuation Standards Council and used in
focus of most real property the International Valuation Standards (IVS) explicitly
appraisal assignments. Both references an “exchange” of property. In those stan-
economic and legal defini-
tions of market value have dards, market value is defined as
been developed and refined, [T]he estimated amount for which an asset or liability
although a multiplicity of should exchange on the valuation date between a willing
sometimes conflicting mar- buyer and a willing seller in an arm’s-length transaction,
ket value definitions used after proper marketing and where the parties had each
for different purposes can acted knowledgeably, prudently and without compulsion.2
present potential problems
in appraisal assignments. The general valuation framework guiding the Inter-
national Valuation Standards reiterates the concept
2. International Valuation Standards Council, International Valuation Standards, Effective 31 January 2020 (London: IVSC, 2019), 18.

that the willingness to trade and the views attributed
to market participants are “typical of those of buyers Various definitions of market
value have been developed
and sellers, or prospective buyers and sellers, active by the Appraisal Institute,
in a market on the valuation date, not to those of any the federal government, the
particular individual or entity.” The market value basis International Valuation Stan-
of valuation described in the International Valuation dards Council, and others.
Standards is consistent with other discussions of mar-
ket value in professional valuation standards.
The Uniform Standards of Professional Appraisal
Practice (USPAP) defines market value conceptually as
[A] type of value, stated as an opinion, that presumes the transfer of a property (i.e., a right of
ownership or a bundle of such rights), as of a certain date, under specific conditions set forth in
the value definition that is identified by the appraiser as applicable in an appraisal.3
It is important to note that USPAP does not provide a citable definition of market
value. Instead, USPAP states that “appraisers are cautioned to identify the exact
definition of market value, and its authority, applicable in each appraisal completed
for the purpose of market value.” Therefore, an appraiser may not cite USPAP as the
source for a definition of market value.
Citable definitions of market value can be found in state and federal regulations,
laws, or publications. For example, the following definition4 of market value is used by
agencies that regulate federally insured financial institutions in the United States:
The most probable price which a property should bring in a competitive and open market under
all conditions requisite to a fair sale, the buyer and seller each acting prudently, knowledge-
ably and assuming the price is not affected by undue stimulus. Implicit in this definition is the
consummation of a sale as of a specified date and the passing of title from seller to buyer under
conditions whereby:
• buyer and seller are typically motivated;
• both parties are well informed or well advised, and acting in what they consider their own
best interests;
• a reasonable time is allowed for exposure in the open market;
• payment is made in terms of cash in US dollars or in terms of financial arrangements compa-
rable thereto; and
• the price represents the normal consideration for the property sold unaffected by special or
creative financing or sales concessions5 granted by anyone associated with the sale.
The definition of market value used by Fannie Mae and Freddie Mac includes addi-
tional discussion of financing and sales concessions:
Adjustments to the comparables must be made for special or creative financing or sales conces-
sions. No adjustments are necessary for those costs that are normally paid by sellers as a result
of tradition or law in a market area; these costs are readily identifiable because the seller pays
these costs in virtually all sales transactions. Special or creative financing adjustments can be
made to the comparable property by comparisons to financing terms offered by a third-party
institutional lender that is not already involved in the property or transaction. Any adjustment
3. Uniform Standards of Professional Appraisal Practice, 2020-2021 ed. (Washington, DC: The Appraisal Foundation, 2020), 5.
4. Section 323.2 amended at 57 Fed. Reg. 9049, March 16, 1992; 59 Fed. Reg. 29501, June 7, 1994; 83 Fed. Reg. 15036, April 9, 2018.
5. See Uniform Residential Appraisal Report Freddie Mac Form 70/Fannie Mae Form 1004 (March 2005), p. 4; also Fannie Mae Single Family 2017
Selling Guide, Definition of Market Value, B4-1.1-01. The Fannie Mae/Freddie Mac definition requires that the effect on property value of any
special or creative financing or sales concessions be determined and that the opinion of value reflect cash-equivalent terms. Special financing
or sales concessions often characterize transactions in depressed markets.
Identifying the Type of Value and Its Definition 49

should not be calculated on a mechanical dollar-for-dollar cost of the financing or concession,
but the dollar amount of any adjustment should approximate the market’s reaction to the financ-
ing or concessions based on the appraiser’s judgment.6
The Uniform Appraisal Standards for Federal Land Acquisitions (which at one time
was referred to informally as “the Yellow Book”) includes the following definition of
market value, which must be used in appraisals performed subject to these standards:
Market value is the amount in cash, or on terms reasonably equivalent to cash, for which in all
probability the property would have sold on the effective date of value, after a reasonable expo-
sure time on the open competitive market, from a willing and reasonably knowledgeable seller
to a willing and reasonably knowledgeable buyer, with neither acting under any compulsion to
buy or sell, giving due consideration to all available economic uses of the property.7
Government and regulatory agencies may redefine or reinterpret market value for spe-
cific types of assignments, so individuals performing appraisal services for these agen-
cies or for institutions under their control must be sure to use the applicable definition.
Client wishes or instructions do not change the basic requirement that apprais-
ers must identify the intended use of the assignment results and use an appropriate
definition of market value for the intended use. Appraisers must understand why the
particular definition of market value should be used in an assignment, apply that defi-
nition according to established standards and recognized practice, and communicate
the requirements of the assignment clearly to the clients they serve.
Other Types of Value

Appraisals of the market value of real property are the most common types of assign-
ments, but appraisers are also called upon by clients to develop opinions of a variety
of other types of value such as the following:
• Fair value
• Use value
• Investment value
• Assessed value
• Insurable value
• Liquidation value
• Disposition value
6. Note that the definition of market value given in the Fannie Mae Selling Guide (May 15, 2014) is worded slightly differently:
Market value is the most probable price that a property should bring in a competitive and open market under all conditions requisite to a
fair sale, the buyer and seller, each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus. Implicit in
this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:
• buyer and seller are typically motivated;
• both parties are well informed or well advised, and each acting in what he or she considers his/her own best interest;
• a reasonable time is allowed for exposure in the open market;
• payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
• the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions
granted by anyone associated with the sale.
7. Interagency Land Acquisition Conference, Uniform Appraisal Standards for Federal Land Acquisitions, 2016 ed. (Washington, DC: The Appraisal
Foundation, 2016), §1.2.4. Elsewhere in the standards document (§4.2.1), market value is defined as follows: “Market value is the amount in
cash, or on terms reasonably equivalent to cash, for which in all probability the property would have sold on the effective date of value, after
a reasonable exposure time on the open competitive market, from a willing and reasonably knowledgeable seller to a willing and reasonably
knowledgeable buyer, with neither compelled to buy or sell, giving due consideration to all available economic uses of the property.”

Differences between Market Value and Contributory Value
The contributory value of a property or a component of a property to the whole is often a consideration in the
development of an opinion of market value, although the distinction between the two types of values should be
observed. The Dictionary of Real Estate Appraisal, 6th edition, provides two definitions of contributory value:
1. A type of value that reflects the amount a property or component of a property contributes to the value of
another asset or to the property as a whole.
2. The change in the value of a property as a whole, whether positive or negative, resulting from the addition
or deletion of a property component. Also called deprival value in some countries.
Contributory value answers the question, “How much does a specific component add to the value of the
property as a whole?” Examples include the following:
• How much do the improvements contribute to the property value?
• How much does the land contribute to the property value?
• How much do the non-realty items (personal property or intangible items) contribute to the property value?
• How much does Parcel A contribute to the value of Parcels A, B, and C if sold together in one transaction?
• How much does a portion of Parcel A contribute to the value of Parcel A?
A property component might be said to have “market value” of a certain amount, but a stricter use of terminolo-
gy would be to describe the “contributory value” of the component in relation to the “market value” of the whole.
The adjustments made in the application of the sales comparison approach for the presence or absence
of a property component in a comparable property are examples of the development of an opinion of
contributory value. Likewise, the cost approach to value is based on the analysis of the contributory value of
individual building components to develop an opinion of market value of the whole property.
In practice, contributory value is most often analyzed as the effect of the value of a part on the value of
the whole. The clearest example is the application of the cost approach in which the contributory value of
individual components of an improved property are tabulated to develop an indication of the market value of
the property as a whole. The inclusion of an estimate of entrepreneurial incentive in cost approach calcula-
tions illustrates that the market value of the property as a whole is often more than simply the sum of the
costs to build a certain set of improvements on a certain site. As another example, consider a parcel of land
with limited value on the open market but with significant contributory value to the owner of the adjacent par-
cel. A common misconception is that the contributory value of the parcel would be equivalent to its market
value because the owner of the adjacent parcel is the most probable buyer. (The concept of assemblage and
its effect on highest and best use is discussed in more detail in Chapters 17 and 18.)
Similarly, a single property can constitute the whole with component parts that provide contributory value
to the market value of the whole. The adjustments made in the application of the sales comparison approach
for the presence or absence of a property component in a comparable property is an example of contributory
value. Likewise, the cost approach to value is based on the analysis of the contributory value of individual
building components to develop an indication of market value of the whole property.
Fair Value
Historically, the accounting profession in the United States has used the depreciated
purchase price to report the value of corporate assets for tax purposes and in finan-
cial statements. In the wake of the auditing scandals that gave rise to the Sarbanes-
Oxley Act of 2002, the International Accounting Standards Board (IASB) and the US
Financial Accounting Standards Board (FASB) changed the generally accepted ac-
counting principles (GAAP) to recognize that fair value is a more accurate measure-
ment. In 2007, FASB defined fair value as follows:
[T]he price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.8
8. Originally defined in Financial Accounting Standard 157, which has been superseded by Financial Accounting Standards Board Accounting Standards
Codification Topic 820: Fair Value Measurements and Disclosures. This definition is identical to the definitions of fair value in International Financial
Reporting Standards (IFRS) 13, Fair Value Measurement, and International Accounting Standards (IAS) 16, Property, Plant, and Equipment.

This definition is more akin to an opinion of market value as appraisers have long
defined the term. Like market value, fair value measurement assumes that the asset
or liability is exchanged in an orderly transaction between market participants to sell
the asset or transfer the liability at the measurement date. An orderly transaction is
a transaction that assumes exposure to the market for a period prior to the measure-
ment date to allow for marketing activities that are usual and customary for transac-
tions involving such assets or liabilities. It is not a forced transaction such as a forced
liquidation or distress sale. The transaction to sell the asset or transfer the liability is a
hypothetical transaction at the measurement date, considered from the perspective of
a market participant who holds the asset or owes the liability. Therefore, the objective
of a fair value measurement is to determine the price that would be received to sell
the asset or paid to transfer the liability at the measurement date (i.e., an exit price).
Market participants are buyers and sellers in the principal (or most advanta-
geous) market for the asset or liability who are
1. Independent of the reporting entity (i.e., they are not related parties)
2. Knowledgeable, having a reasonable understanding about the asset or liability
and the transaction based on all available information, including information that
might be obtained through due diligence efforts that are usual and customary
3. Able to transact for the asset or liability
4. Willing to transact for the asset or liability (i.e., they are motivated but not forced
or otherwise compelled to do so)
The fair value of the asset or liability should be determined based on the assumptions
that market participants would use in pricing the asset or liability.
A fair value measurement assumes the highest and best use of the asset by mar-
ket participants, considering the use of the asset that is physically possible, legally
permissible, and financially feasible at the measurement date. The highest and best
use of the asset establishes the valuation premise used to measure the fair value of
the asset, specifically:
1. In use. The highest and best use of the asset in use
would provide maximum value to market partici-
The market value concept is pants principally through its use in combination
sometimes also called fair with other assets as a group.
market value, though it could
be argued (as stated in a 2. In exchange. The highest and best use of the asset
1943 United States Supreme is in exchange if the asset would provide maximum
Court decision) that the term value to market participants principally on a stand-
“fair” adds little to the phrase alone basis.
“market value.” The Dictionary
of Real Estate Appraisal, 6th The real estate appraiser may need to report both val-
edition, indicates fair market ues so that the user of the report can make an informed
value to be “equivalent” to decision.
market value in nontechni-
cal usage and “similar in
concept” with respect to tech- Use Value
nical usage in condemnation, Market value opinions are based on the highest and
litigation, and tax situations. best use of a property. In contrast, use value is the
value that a specific property has for a specific use,

which may or may not be the highest and best use of
the property. use value
Use value has very limited application. However, The value of a property as-
suming a specific use, which
court decisions and specific statutes may create the may or may not be the prop-
need for use value appraisals. For instance, many states erty’s highest and best use on
require agricultural use appraisals of farmland for the effective date of the ap-
property tax purposes (i.e., value based on soil produc- praisal. Use value may or may
tivity) rather than opinions of value based on highest not be equal to market value
but is different conceptually.
and best use. The current IRS regulation on estate taxes
allows land under an interim agricultural use to be
valued according to this alternative use even though
the land has development potential.9 Also, a seminal ruling in California, which has
been cited in other jurisdictions, involved the appraisal of properties subject to title
claims. In Overholtzer v. Northern Counties Title Insurance Company, the value diminu-
tion caused by a defect in title was measured by the use of the property when the
defect was discovered, not the highest and best use of the property.10
Use Value, Value in Use, and Investment Value in the IVS

The term value in use has often been used by real estate appraisers synonymously
with use value, but value in use is a different concept. In the IVS, value in use is the val-
ue the real estate (or any asset) contributes to the enterprise of which it is a part—i.e.,
what was called contributory value earlier in this chapter. It is the amount the property
would add to the sale price of the enterprise. For example, assume a specialty manu-
facturer has a new building constructed at a cost of $5 million including an appropri-
ate developer fee. Assume also that the building perfectly suits the manufacturer’s
needs and that profits from the manufacturing operation are in excess of the amount
necessary to justify the cost of the building. It would be reasonable to conclude that,
if the enterprise sold, the building would contribute $5 million to its price. Therefore,
its value in use would be $5 million. On the other hand, an appraiser might conclude
that if the building was sold separate and apart from the business or any other asset,
it would sell for only $3.5 million because the specialized building features do not
add utility for other tenants. In that case, the value in exchange is $3.5 million, but
the value in use is $5 million.
The International Financial Reporting Standards defines value in use as “the
discounted present value of estimated future cash flows expected to arise from the
continuing use of an asset and from its disposal at the end of its useful life.” This
definition is paraphrased in the International Valuation Standards application related
to valuation for financial reporting. In the case of real estate, the cash flows from use
of the asset are the net amount of rent that is saved by owning the property. In the
example in the previous paragraph, the specialty manufacturer has two options: (1)
spend $5 million to have a building constructed or (2) bid the project out to a devel-
oper who would invest the $5 million and lease the property to the manufacturer at
an appropriate rent. If the manufacturer owns the building, value in use can be calcu-
9. The section on special-use valuation in United States Estate (and Generation-Skipping Transfer) Tax Return (IRS Instructions for Form 706) states:
“Under section 2032A, you may elect to value certain farm and closely held business real property at its farm or business use value rather than
its fair market value (FMV). Both special-use valuation and alternate valuation may be elected.”
10. Overholtzer v. Northern Counties Title Insurance Company, 116 Cal.App.2d 113 (Calif. 1953).

lated by discounting back the rent savings and the reversion at an appropriate rate.
Theoretically, if a lease was competitively bid, the value in use by discounted cash
flow analysis should be similar to the depreciated replacement cost of the property.
Earlier editions of the International Valuation Standards included a definition of
value in use as part of International Valuation Standard 2: Bases Other Than Market
Value, but that definition was eventually deleted, eliminating the possible confusion
between value in use and investment value. In the IVS, the current definition of invest-
ment value is not specifically related to financial reporting as value in use now is.
Investment Value
As used in appraisal assignments, investment value is the value of a property to a
particular investor based on that person’s (or entity’s) investment requirements,
rather than market norms. In contrast to market value, investment value reflects the
subjective relationship between a particular investor and a given investment. In other
words, investment value is the price an investor would pay for an investment in light
of its perceived capacity to satisfy that investor’s desires, needs, or investment goals.
The concepts of investment value and market value are fundamentally different,
but indications of investment value and market value may sometimes be similar. If
the investor’s requirements are typical of the market, investment value in this case
will be the same as market value.
To render an opinion of investment value, an ap-
investment value praiser must research the specific investment criteria
The value of a property to a of the party in question. As an example, suppose that a
particular investor or class of real estate investment trust (REIT) is aggressively buy-
investors based on the inves-
tor’s specific requirements; ing Class A apartments that meet its specific criteria.
may be different from market For properties that meet the criteria, the REIT is willing
value because it depends on to base the acquisition on a 7% discount rate, even
a set of investment criteria though the typical market discount rate for comparable
that are not necessarily typi- investments is 8%. To assist in the REIT’s purchasing
cal of the market.
decisions, an appraiser might be engaged to provide
opinions of investment value for each potential acquisi-
tion target using discounted cash flow analysis at a 7%
Public Interest Value discount rate over a specified holding period. In this
Historically, public interest example, investment value is different than market
value has been used as value because the 7% discount rate is not typical of the
a general term covering a market. If other investors begin making offers based on
family of value concepts that a 7% discount rate, that discount rate would become
relate the highest and best the market rate, and investment value to the REIT
use of property to noneco-
nomic uses. (Other terms would become equal to market value.
for similar concepts include As another example, suppose a real estate develop-
aesthetic value, scenic value, er who owns both an office building and a hotel sees an
preservation value, and opportunity to acquire the vacant land parcel situated
social value.) The analysis of between the two existing properties. By developing the
public interest value tends to
be driven by social, political, vacant land parcel as a retail center, the developer can
and public policy goals rather potentially enhance the value of both the office build-
than economic principles. ing and the hotel. Therefore, the developer can afford
to pay more for the vacant land than other market par-

ticipants could. An appraiser is asked to provide an opinion of investment value that
includes not only the underlying value of the land but also the value enhancement to
the adjoining properties.
Assessed Value
In ad valorem taxation, assessed value refers to the value of a property according to the
tax rolls. The International Association of Assessing Officers provides two definitions
of assessed value:
1. A value set on real estate and personal property by a government as a basis for
levying taxes.
2. The monetary amount for a property as officially entered on the assessment roll
for purposes of computing the tax levy. Assessed values differ from the assessor’s
estimate of actual (market) value for three major reasons: fractional assessment
ratios, partial exemptions, and decisions by assessing officials to override market
value. The process of gathering and interpreting economic data to provide infor-
mation that can be used by policymakers to formulate tax policy.11
Assessed value is usually calculated in relation to a market value basis. Some mu-
nicipalities estimate both an assessed value and a market value. Appraisers of real
property are generally not asked to develop an opinion of assessed value, although
in property tax disputes appraisers are often asked by property owners to provide an
opinion of market value for comparison with the assessed value. Appraisers are also
often asked to determine the fairness or uniformity of the assessed value of properties.
Insurable Value
Traditionally, the value of an asset or assets covered by an insurance policy has been
known as the insurable value, even though the amount is more accurately an indica-
tion of cost. The maximum reimbursement for direct physical damage or loss of prop-
erty is limited to the amount shown on the contract. This value is often controlled by
state law and varies from state to state.
The objective of an insurance policy is to compensate the insured party for the
loss. Insurable value may be based on the replacement or reproduction cost of physi-
cal items that are subject to loss from hazards. Land value is not included in the in-
surable value, and items such as underground piping and below-grade foundations
are typically excluded as well.
When asked to provide insurable value, an appraiser must identify and report
the definition used and ensure that the analyses and conclusions are consistent with
that definition.
Disposition Value and Liquidation Value

Sales of properties in distressed markets often do not meet the conditions specified
in the definition of market value. Other types of value might be more appropriate for
properties when a forced sale or some other form of distress is influencing the deci-
sions of the buyer or seller. In 1992, the Special Task Force on Value Definitions of
the Appraisal Institute developed definitions of disposition value and liquidation value,
11. International Association of Assessing Officers, Glossary for Property Appraisal and Assessment, 2nd ed. (Kansas City: IAAO, 2013), s.v. “assessed value.”

and with minor changes to the wording over the years those value definitions remain
relevant for certain appraisal assignments.
The definition of disposition value is
The most probable price that a specified interest in property should bring under the following
conditions:
1. Consummation of a sale within a specified time, which is shorter than the typical exposure
time for such a property in that market.
2. The property is subjected to market conditions prevailing as of the date of valuation.
3. Both the buyer and seller are acting prudently and knowledgeably.
4. The seller is under compulsion to sell.
5. The buyer is typically motivated.
6. Both parties are acting in what they consider to be their best interests.
7. An adequate marketing effort will be made during the exposure time.
8. Payment will be made in cash in US dollars (or the local currency) or in terms of financial ar-
rangements comparable thereto.
9. The price represents the normal consideration for the property sold, unaffected by special or
creative financing or sales concessions granted by anyone associated with the sale.
This definition can also be modified to provide for valuation with specified financing terms.
The definition of liquidation value is

The most probable price that a specified interest in property should bring under the following
conditions:
1. Consummation of a sale within a short time period.
2. The property is subjected to market conditions prevailing as of the date of valuation.
3. Both the buyer and seller are acting prudently and knowledgeably.
4. The seller is under extreme compulsion to sell.
5. The buyer is typically motivated.
6. Both parties are acting in what they consider to be their best interests.
7. A normal marketing effort is not possible due to the brief exposure time.
8. Payment will be made in cash in US dollars (or the local currency) or in terms of financial ar-
rangements comparable thereto.
9. The price represents the normal consideration for the property sold, unaffected by special or
creative financing or sales concessions granted by anyone associated with the sale.
This definition can also be modified to provide for valuation with specified financing terms.
The definitions of disposition value and liquidation value are similar except for the
wording of the numbered elements 1, 4, and 7. The differences are largely matters
of degree, e.g., “under compulsion to sell” in the definition of liquidation value as op-
posed to “under extreme compulsion to sell” in the definition of disposition value.
According to Guide Note 11 of the Standards of Professional Practice of the
Appraisal Institute: Comparable Selection in a Declining Market, market value assign-
ments address the following question:
What would the property likely sell for on the date of value after a typical exposure period on
the open market?
In contrast, a disposition value assignment answers a different question:

What will the property likely sell for after a limited exposure on the market given the seller is
compelled to sell?

A liquidation value assignment answers yet another question:
What will the property likely sell for after a severely limited exposure on the market given the
seller is extremely compelled to sell?12
In the case of both disposition value and liquidation value, the limited or severely
limited exposure time on the market is specified by the client. If that time period is
the same as what is typical in the current market, disposition value could be equal to
market value.
12. Guide Notes to the Standards of Professional Practice of the Appraisal Institute: Guide Note 11: Comparable Selection in a Declining Market
(Chicago: Appraisal Institute, 2017), www.appraisalinstitute.org.

Identifying the Rights to 7
Be Appraised
In the first step of the valuation process, an appraiser identifies the rights to be ap-
praised, which is a practical application of the bundle of rights theory in a real prop-
erty appraisal assignment. The real property rights to be appraised are singled out
among the relevant characteristics of the property because, like the appropriate type
and definition of value for the assignment, the property rights to be appraised are a
fundamental assignment element.
Real property appraisal involves not only the identification and valuation of a
variety of different rights, but also analysis of the many limitations on those rights
and the effect of those limitations on the valuation. Some limitations, such as eminent
domain, are public, while others, such as deed restrictions, are private. These limita-
tions are rights that are not held by the property owner. For example, the government
holds the right of eminent domain, and the property owner gives up the right to use
and occupy the condemned portions of the property in the event that the government
exercises its right.
The terms of art title, estate, and interest may be defined differently in different
jurisdictions and by different professions. At the same time, the terms—particularly,
estate and interest—might be used so loosely by market participants that they effec-
tively function as synonyms. In simplest terms, title is proof of ownership. An estate
is what is owned, including the right of possession and the power to exclude others.
And interests are rights in real property that can benefit or burden the land and affect
the value of an estate.
What is valued in a real property appraisal is an estate subject to specified
interests. Therefore, an appraiser’s task is to identify not only the estate (e.g., the fee
simple estate, the leasehold estate, the leased fee estate, the life estate) but also the in-
terests associated with the real estate, such as leases, easements, restrictions, encum-
brances, reservations, covenants, contracts, declarations, special assessments, ordi-
nances, or other interests of a similar nature. In valuation practice, it is not necessary
to label estates and interests in a prescriptive manner as long as all relevant property
rights are identified in a manner that the intended users can understand.
The Fee Simple Estate
The most complete form of ownership is the fee simple estate—i.e., absolute owner-
ship unencumbered by any other interest or estate, subject only to the limitations
imposed by the governmental powers of taxation, eminent domain, police power,
and escheat. Of course, an appraiser may be asked to value something other than the
fee simple estate—i.e., a partial interest or a fractional interest.
Sometimes described as an absolute property right, a fee simple estate is not, in
fact, absolute because it is subject to the four powers of government (i.e., taxation,
eminent domain, police power, and escheat). Nevertheless, an owner of a fee simple
estate has broad rights. The complete bundle of rights includes, but is not limited to,
the following:
• The right to sell an interest
• The right to transfer an interest
• The right to lease an interest
• The right to occupy the property1
• The right to mortgage an interest
• The right to give an interest away
According to The Dictionary of Real Estate Appraisal, 6th ed., the term fee simple
estate is defined as
Absolute ownership unencumbered by any other interest or estate, subject only to the limitations
imposed by the governmental powers of taxation, eminent domain, police power, and escheat.
By this definition, a fee simple estate includes the full “bundle of rights” with no ex-
ceptions other than the four specified governmental powers. Strictly interpreted, even
minor encumbrances like public utility easements or reciprocal access agreements
would result in something less than a fee simple estate. This full bundle of rights
concept is a helpful valuation theory because it establishes a benchmark to which the
rights being valued can be compared. However, by this measure, few properties and
few sales transactions involve a fee simple estate. Nevertheless, as a practical matter,
most appraisers refer to all fee interests in real property as fee simple, regardless of the
encumbrances, unless one of those encumbrances is a lease. This practice does not im-
ply that appraisers ignore encumbrances other than leases but rather that those factors
are implicitly accounted for under the fee simple classification in common usage.
The legal profession defines the term fee simple slightly differently than the valu-
ation profession does because legal definitions generally serve a different purpose.
Whereas definitions of fee simple used by the appraisers highlight the encumbrances
on property, legal definitions tend to focus on duration. That is, legal definitions of
the term generally do not mention the four powers of government or encumbrances.
Instead, in a legal setting, the fee simple estate is one that endures for an indefinite pe-
riod, as opposed to an estate of a shorter duration like a life estate or term of years. For
example, in Black’s Law Dictionary, 11th ed., the term fee simple is defined as follows:
An interest in land that, being the broadest property interest allowed by law, endures until the
current holder dies without heirs, esp. a fee simple absolute.
1. The right to occupy a property is subject to government entitlements such as zoning and occupancy permits that require certain conditions on
site such as curb cut permits, access, drainage, and utilities.

This definition contains
several key concepts: the The Concept of Possession
concept that fee simple is As a legal concept, possession is the power to exclude others, and
it is what makes an estate different from an interest in property. To
a possessory interest in the
be an estate in land, the legal right or interest must allow posses-
land (i.e., it is the “broad- sion—now or in the future—and specify duration. Possession (the
est” form of ownership) power to exclude) is not identical to occupancy (the actual physical
and the concept of inherit- use of the property), and more than one party may have possessory
ability (i.e., permanence). rights at any given time. For example, a landlord and a tenant both
have possessory rights to exclude others. Because each party has a
According to this defini-
possessory right, each has an estate. Specifically, the landlord has
tion, a significant char- the fee simple estate and the tenant has the leasehold estate. In
acteristic of a fee simple contrast, the holders of other types of interests in a property (such as
estate is that it is unlimited a mortgagee or the beneficiary of an easement) have no possessory
as to duration, transfer- right and hence no power to exclude others.
ability, and inheritability,
in contrast to leaseholds
(which are limited to the
lease term), life estates (limited to the life of a specific person), and other limited estates.
A lender requesting a valuation of the fee simple estate likely intends to refer to an
unencumbered interest, whereas a deed that conveys fee simple title would generally be
understood to mean an interest that will endure indefinitely, including all encumbrances.
Appraisers must clearly identify—and appraisal reports must clearly convey—
the property rights that are the subject of an appraisal. In the case of a fee simple
estate, a definition on its own may not be adequate. The appraisal report should
clearly state any encumbrances affecting the property. The underlying premises of
the valuation, including any expectations about occupancy, must be identified by the
appraiser and clearly stated in the appraisal report. The methods applied to arrive at
the value opinion must reflect the presumed conditions.
In some cases, “what is to be valued”—particularly the interest to be appraised
and the definition of that interest—is dictated by applicable law or regulation. Ap-
praisers are responsible for knowing which laws or regulations apply and for com-
plying with those laws and regulations.
A partial interest is any interest or group of interests that makes up less than the
entire bundle of rights. Partial interests can be created in several ways:
• Economically
• Legally
• Physically
• Financially
The remainder of this chapter examines how to identify and categorize property
rights that are less than the complete bundle of rights.
Economic Interests
The most common type of economic interest in property is created by a lease. In this
arrangement, a lessor and a lessee each hold partial interests, which are stipulated
in contract form and are subject to contract law. In the case of subleases, additional
leasehold interests are created. In those cases, an occupant’s interest is commonly
Identifying the Rights to Be Appraised 61

referred to a subleasehold. The intervening leasehold
Leases specify the rights of interest is commonly referred to as a sandwich leasehold
the lessor (e.g., to collect
rent, to get the property because the holder of the sandwich leasehold is the ten-
back when the lease expires, ant on one lease and the landlord on another.
to dispose of the property Terms such as fee simple, leased fee, and leasehold
through sale or transfer) should be used with care. Appraisers should recognize
and the rights of the lessee that these terms may have different meanings outside
(e.g., to use, occupy, and, in
some cases, to improve or to appraisal practice and in different jurisdictions, and that
sublease the property). the terms used alone may be inadequate to convey the
meaning of what is being valued, i.e., both the estate and
the interests as well as the premises of the valuation.
Leasehold
The leasehold is the lessee’s, or tenant’s, estate. When a lease is created, the tenant
usually acquires the rights to possess the property for the lease period, to sublease
the property (if this is allowed by the lease), and perhaps to improve the property
under the restrictions specified in the lease. In return, the tenant is obligated to pay
rent, to give the property back at the end of the lease term, to remove any improve-
ments that the lessee has modified or constructed (if specified), and to abide by the
lease provisions. The most important obligation of a tenant is to pay rent.
The relationship between contract rent and market rent greatly affects the value of
a leasehold. A leasehold may have value if contract rent is less than market rent, creat-
ing a rental advantage for the tenant. However, the contract advantage of the lease-
hold may not be marketable. For example, the original lease contract may prohibit
subletting or assigning, or the remaining lease term may be too short to be marketable
to potential sublease tenants or assignees. This relationship, in turn, is likely to affect
the value of the leased fee. The value of a leased fee encumbered with a fixed rent that
is below market rates may be less than the value of the fee simple or the leased fee
with rent at market levels. When contract rent exceeds market rent, the leasehold is
said to have negative value. Even in such circumstances, the tenant still has the right
to occupy the premises and, despite the contractual disadvantage, may have other
benefits that warrant continued occupancy. It is also possible that the contract disad-
vantage hurts the tenant’s business and increases the risk of continued occupancy.
Leased Fee
In appraisal practice, the lessor’s, or landlord’s, position is referred to as the leased fee.
The rights of the lessor and the lessee are specified by contract terms contained in the
lease. Although the specific details of leases vary, a lease generally provides the lessor
with the following:
• Rent to be paid by the lessee under stipulated terms
• The right of repossession at the termination of the lease
• Default provisions
In appraisal practice, the lessor’s interest in a property is considered a leased fee re-
gardless of the duration of the lease, the specified rent, the parties to the lease, or any
of the terms in the lease contract.

Subleasehold or Sandwich Interests
A lease contract may allow a tenant to sublease all or part of a property, but many
leases require that the landlord’s consent be obtained. A sublease is an agreement in
which the tenant in an existing lease conveys to a third party the interest that the les-
see enjoys (the right of use and occupancy of part or all of the property) for part or all
of the remaining term of the lease. In a sublease, the original lessee is “sandwiched”
between a lessor and a sublessee (see Figure 7.1). The original lessee’s interest has
value if the contract rent is less than the rent collected from the sublessee or if the
lease conveys other economic advantages. (For example, a lease might have a ben-
eficial purchase option.) Subleasing does not release the lessee from the obligations
to the lessor defined in the lease agreement. A sublease may affect all the parties,
including the leased fee position.
Figure 7.1 Sandwich Position in a Sublease Transaction
Sandwich Position
Lessee 1/Lessor 2
Lessor 1 Lessee 2
(original tenant/
(original landlord) (sublessee)
sublessor)
Right of Use Right of Use Right of Use

and Occupancy and Occupancy and Occupancy
(Lessor 1 transfers (Lessor 2 transfers (Lessee 2 receives
to Lessee 1) to Lessee 2) from Lessor 2)
Compensation in Compensation in Compensation in

the Form of Rent the Form of Rent the Form of Rent
(Lessor 1 receives (Lessee 1 pays (Lessee 2 pays
from Lessee 1) to Lessor 1) to Lessor 2)
Leased Fee Sandwich Subleasehold

Interest Leasehold Interest Interest
As an example, consider a developer who builds a five-story building on land

that is leased for 99 years and who then leases parts of the buildings to others. The
vacant land owner is the lessor, the developer is the lessee (and sublessor), and the
tenants in the building are sublessees.
A lease contract may contain a provision that explicitly forbids subletting.
Without either the right to sublet or a term that is long enough to be marketable, a
leasehold position may have no market value. (Only when a lease is assignable can
the leasehold have market value because market value is based on a hypothetical
exchange.) Furthermore, the value of the leased fee estate would likely be diminished
in this case because a lessee who no longer has need of the leased premises and is not
allowed to sublease the space is more likely to default on the lease, thus increasing
the riskiness of the income stream to be received by the lessor.

Legal Interests
Virtually every property is subject to some kind of easement or other legal restriction
on use. Some are permanent easements, while others may only exist for a short peri-
od of time. Often appraisers have to either value the property subject to an easement
or value the easement itself. In certain situations, a life estate may be created, which
in turn creates several partial interests. Transferable development rights are another
type of partial interest created by legal circumstances.
Life Estates
A life estate is defined as the rights of use, occupancy, and control of a specified prop-
erty limited to the lifetime of a designated party. The designated party is generally
known as the life tenant and is obligated to maintain the property in good condition
and pay all applicable taxes during the term of the life estate. Two interests are created
by a life estate, and both may need to be valued by an appraiser. The first interest is that
of the life tenant. The second is the remainder interest, i.e., the possessory interest in the
property upon the death of the life tenant. Life estates can be created in several ways:
• By operations of law
• By wills
• By deeds of conveyance
For example, a fee owner may leave a will that gives land to his widow for her re-
maining lifetime and, at her death, the land is passed on to their children. Thus, the
widow acquires a life estate and functions as a life tenant with the children becoming
the holders of the remainder interest. A living fee owner may deed his property to a
family member as the holder of the remainder interest and, by the terms of the con-
veyance, retain a life estate. This practice might eliminate the expense of probating
the will after the owner dies, but it may also call for the assessment of a gift tax.
A related property interest that an appraiser may be asked to value is known as
a “springing executory interest.” Like a life estate, a springing (or “shifting”) interest
transfers certain rights of ownership to a designated party under certain contractual
conditions such as the occurrence of a specific event. An example of a springing inter-
est would be the right of use of a property assigned to a parent that is extinguished in
the future when that person’s child reaches a certain age—say, 21—at which point the
rights of ownership are transferred to the child.
Easements
An easement is an interest in real estate that transfers use, but not ownership, of
a portion of an owner’s property. Easements usually permit a specific portion of a
property to be used for identified purposes, such as access to an adjoining property
or as the location of a certain underground utility. Although surface easements are
the most common, subterranean and overhead easements are used for public utili-
ties, fiber-optic cables, subways, and bridges. Other types of easements such as
scenic easements and facade easements may prohibit the owner of the underlying fee
simple estate from certain uses of the property without giving the holder of the ease-
ment any possessory interest in the real estate.
Clearly a property that enjoys the benefit of an easement gains additional rights,
while a property that is subject to an easement is burdened. The easement attaches

to the property benefitted and is referred to as an easement appurtenant. The property
that is benefitted by an appurtenant easement is known as the dominant tenement. The
property that is subject to the easement is called the servient tenement.
Easement rights can be transferred in perpetuity or for a limited time period. An
easement can be created in several ways:
• By a contract between private parties
• By prescription or implication
• By governmental entities or public utilities through the exercise of eminent domain
A conservation easement is a typical example of a contract between private parties,
in which case a landowner enters into an agreement with a qualified conservation
group that limits the future use of a portion of the owner’s property, often to ensure
that some natural environment will not be developed.2 The property owner hands
over certain specified rights of use and receives a tax deduction. In exchange, the con-
servation group may or may not pay compensation (and offer ongoing property tax
savings). An example of an easement created by prescription might be a right of ac-
cess granted to the public who for many years have used a trail as a shortcut through
a parcel of privately owned land. Public utilities often have certain limited powers of
eminent domain that they may use to impose a temporary construction easement and
an access easement on private property to install and maintain equipment such as a
natural gas pipeline or electrical lines and towers.
Transferable Development Rights

Transferable development rights (TDRs)—sometimes referred to as severable use rights
(SURs) and often associated with air rights—emerged in the real estate industry dur-
ing the 1970s. A transferable development right is a development right that is separat-
ed from a landowner’s bundle of rights and transferred, generally by sale, to another
landowner in another location. Some TDRs preserve property uses for agricultural
production, open space, or historic buildings. In this arrangement, a preservation, or
sending, district and a development, or receiving, district are identified. Landowners
in the preservation district are assigned development rights, which they cannot use
to develop their own land but can sell to landowners in the development district. The
landowners in the development district can use the transferred rights to build at high-
er densities than zoning laws in the development district would normally permit.
Another situation in which development rights are transferred results from the
constrained capacity of an existing utility. For example, consider a community that
decides to impose a construction moratorium pending the expansion of its present
sewage plant or the building of a new plant. Before the moratorium, a landowner
was granted the right to hook up 100 projected single-unit residences to the existing
plant. A second landowner, however, did not obtain the right to link up 50 proposed
single-unit residences to the sewage treatment plant and will have to wait for expan-
sion of the plant’s capacity. The second landowner risks financial loss if that individ-
ual cannot develop the land immediately, so the second landowner eagerly purchases
the right to link up 50 residential units to the plant from the first landowner.
2. Internal Revenue Code §170A 14(c)(1) describes the qualified organizations eligible to be considered an eligible donee, which include certain
governmental units, charitable organizations that meet the public support test, and other charitable organizations that are controlled by organiza-
tions described in that section of the IRC.

Although transferable development rights may vary from state to state, these
rights are generally real property only as long as they are attached to the land. When
they are sold, they become personal property, only becoming real property again
when they are attached to another tract of land. TDRs can often be banked to facili-
tate the timing of the transfer of rights.
Physical Interests
Physical interests in real property can be separated either horizontally or vertically.
The most common methods of creating horizontal divisions of real property are
through subdivision and assemblage. In subdivision, a large tract of land is broken
down into smaller units, which are then marketed individually. In assemblage, two
or more parcels of real estate are combined into one parcel. When the value of the
assembled parcel is greater than the sum of the values of the individual parcels, the
incremental value created by the assemblage is known as plottage value. Consider
two adjacent, half-acre office sites in a central business district where one-acre sites
are more desirable. The value of each half-acre site is $500,000, but when assembled
the one-acre site has a value of $1,200,000. Conversely, when potential buyers prefer
smaller sites, the unit values of larger sites will likely be lower.
The most common vertical interests in real property are (a) subsurface rights
and (b) air rights. A subsurface right is the right to the use of and profits from the
underground portion of a designated property. The term usually refers to the right to
extract minerals from below the earth’s surface and to construct tunnels for railroads,
motor vehicles, and public utilities. Air rights are the property rights associated with
the use, control, and regulation of air space over a parcel of real estate.
The vertical division of real property is significant because engineering advances
have dramatically affected land use and, therefore, highest and best use consider-
ations. The development of steel-framed building construction, the passenger eleva-
tor, deep tunnel excavation techniques, and innovations in communications technol-
ogy have all helped to shape the modern urban landscape. As the density of building
in urban areas increases, fewer sites are available for new construction and land
values escalate, increasing the demand for opportunities to develop air rights.
Air rights can be sold or leased, with the seller retaining one or more easements
for a specialized use such as the operation of a railroad line on the land beneath the
improvements developed in the vertical space above the parcel. Air rights may be
subdivided as well, as when the owner of the fee simple interest sells or leases only
the land and air that are to be occupied by a particular improvement.
Air rights can also be transferred in various ways. Often the air rights to one
property are shifted to another property within the same building zone under legal
planning regulations. The transfer of air rights can allow developers to adjust the
density of land use without putting adverse pressure on owners, neighborhoods, or
districts. This practice underscores the importance of local zoning authorities, which
regulate building heights, building functions, setbacks, and other variables involved
in the development of air rights. As an example, a common form of air rights transfer
in New York City involves merging two lots. A developer will buy adjacent lots so
that the larger combined lot area will be used in calculations of floor area ratio (FAR),
i.e., the measure in the local zoning code that dictates how large a building can be. If
the area of the combined parcel is twice that of the original site of the new building,

the allowable aboveground area of the new building could be doubled by building
higher without violating the maximum floor area ratio. In effect, the allowable use of
the airspace above one of the original parcels (say, an existing low-rise commercial
building) is transferred to the other parcel (a new high-rise residential building).
Financial Interests
The financial aspects of property interests have a major effect on real estate invest-
ment practices. The analysis of mortgage and equity components is of particular
importance. Mortgage funds are secured debt positions, while equity investments are
venture capital. Fee simple, leased fee, and leasehold interests can all be mortgaged,
thereby subdividing these interests into mortgage and equity components.
Equity Interests
The equity in real property is the owner’s interest after In the analysis of partial
all claims and liens have been satisfied. An equity inter- interests, appraisers should
keep in mind that the value
est, like a mortgage loan, represents a financial interest
of a partial interest is not
in real property. Equity ownership in real property necessarily a pro rata share
can be legally accomplished in many ways—e.g., as an of the value of the whole.
individual owner, joint owner, partner, or shareholder For example, if the value of
in a corporation. the fee simple interest is $1
million, a 40% interest is not
The legal form of equity ownership does not affect
necessarily worth $400,000.
property value in most appraisal assignments. How- Partial interests are often
ever, an appraiser is sometimes called upon to render valued at less than their
an opinion of the value of a specific legal form of equity pro rata share of ownership,
interest. For example, an appraiser may be asked to especially if the holder of the
partial interest does not have
value an equity interest for estate tax purposes or for
any voice in the manage-
sale or purchase decisions. ment or control of the asset.
Mortgage Interests
A mortgage instrument creates mortgagor and mort-
gagee positions. In investment analysis assignments and other assignments, ap-
praisers are often asked to research the value of mortgage interests. Mortgage-equity
analysis has a long history in appraisal literature (see Chapter 25), and techniques
for comparing the value of mortgages with different terms are well established (see
Chapter 21).
Mortgage interests trade regularly in the secondary market, with varying degrees
of governmental intervention to promote liquidity and competition. Conditions in the
mortgage market can have a tremendous effect on property value, as was seen in the
economic downturn that followed the housing crisis beginning in 2007. Economic trends
involving the mortgage and capital markets are discussed more fully in Chapter 10.
Forms of Ownership
The various property interests described earlier in this chapter can be owned by in-
dividuals, by a group, or by various legal entities that are defined by state law in the
United States. Identifying the relevant form of ownership of the assets involved in an
assignment is part of an appraiser’s investigation into the rights to be appraised. In

effect, the forms of ownership discussed in this final section of the chapter identify
who owns the interests discussed previously (i.e., what is owned).
Concurrent Ownership of Real Property

Individual ownership is legally known as ownership in severalty. However, individu-
als can hold ownership under certain legal entities, such as 100% ownership of the
beneficial interest in a land trust or 100% ownership of the stock of a corporation that
owns real estate. Tenancy is defined as the holding of property by any form of title.
Concurrent ownership includes joint tenancy, tenancy by the entirety, and tenancy
in common. Joint tenancy is joint ownership by two or more persons with the right of
survivorship. Under this arrangement, each party has an identical interest and right of
possession. Upon the death of one joint tenant, ownership is automatically vested in the
remaining joint tenant or tenants. In states that allow tenancy by the entirety, ownership
is held by spouses in which neither has a disposable interest in the property during the
lifetime of the other, except through joint action. It has the same survivorship provision
as a joint tenancy, but tenancy by the entirety applies only to spouses. Tenancy in com-
mon is an estate held by two or more persons, each of whom has an undivided interest.
In this estate the undivided interests may or may not be equally shared by the holders
and there is no right of survivorship. One tenant in common may sell off an undivided
interest without the approval or knowledge of the other tenant or tenants in common.
Legal Entity Ownership of Real Property

In addition to individual ownership, real property can be owned by a variety of dif-
ferent legal entities such as
• Land trusts
• Partnerships
• Corporations and companies
• Syndications
Like individuals, these entities can own a fee simple interest or partial interests in
real property.
A group of real estate investors often choose one form of ownership over another
to take advantage of tax savings offered by a particular ownership structure, to limit
personal liability through a different form of ownership, or to avoid corporate report-
ing. The legal framework for all these ownership structures can vary by state, so
investors may favor certain structures in different states or may even incorporate in
another state after comparing the advantages and disadvantages of the relevant laws
in different states.
Land Trusts
Trusts are sometimes used as legal vehicles to create partial ownership interests in real
property. In a land trust, one or more properties are conveyed by special deed to a trust-
ee, which then conditionally owns the real property. Either the original owners or some
other designated individual or persons become the owners of the beneficial interest in the
trust. A trust agreement is established to outline the duties and functions of the trustee.
A trustee can take no actions other than those specified and allowed in the trust
agreement without written permission of the owner or owners of the beneficial
interest. For example, in one trust agreement a trustee may be required to manage a

property actively and collect rents. However, in another trust agreement regarding a
different property, the same trustee might be prohibited from managing the property
and collecting rents. One important legal aspect of a trust arrangement is that a judg-
ment against a beneficiary is not a lien against the real estate.
Partnerships
A partnership is a business arrangement in which two or more persons jointly own a
business and share in its profits and losses. Partnerships are used extensively in real
estate acquisition because they pool individual funds for property ownership and op-
eration. Two types of partnerships are prevalent in the ownership of real property: (1)
general partnerships and (2) limited partnerships.
In a general partnership, all partners share in business gains and each is person-
ally responsible for all liabilities of the partnership. Limited partnerships have both
general partners and limited partners. All partners participate by pooling funds.
However, unlike general partnerships in which all partners actively participate in the
business of the partnership, in a limited partnership the partners can be either active
or passive. General partners are active members of the partnership who manage the
business and assume full liability for partnership obligations. Limited partners, on the
other hand, are passive members of the partnership. They are not actively involved in
the business of the partnership, and their liability is restricted to the amount of their
capital contribution. Through a limited partnership, a group of investors can jointly
acquire real property that they might be unable to acquire as individuals.
Stock Corporations
Like partnerships, stock corporations allow many investors to pool funds to purchase
and own real property. However, unlike partnerships, the individual investors in a
stock corporation do not hold an interest in the real property. Rather, they own shares
of stock, usually recognized as personal property, that can be private or publicly
traded. The owner of the real property is the legal entity, the corporation.
A stock corporation may be organized to hold title to a single asset, such as a
parcel of real estate, or multiple assets, such as a portfolio of property investments.
Real Estate Investment Trusts and Real Estate Operating Companies

Real estate investment trusts (REITs) have been successful in pooling the funds of small investors to acquire
real estate investment positions that could not be handled by these investors individually. Buying shares of
REIT stock is not the same as direct investment in a given property. REITs offer shareholders freedom from
personal liability, the benefit of expert management, and readily transferable shares. To qualify for a tax pass-
through, a REIT must pay dividends of at least 90% of its taxable income. With complicated income-measuring
practices, these trusts attempt to pay out almost all their net income and, therefore, are substantially restricted
in establishing reserves for possible losses. The liquidity of these securities is an attractive feature to investors.
While the stock market establishes the value of REITs, the income performance of these assets tracks the
performance of real estate markets. REIT prices tend to be less volatile than the Standard & Poor’s 500, and
the correlation between large cap stocks and REITs has been declining since 1990.
The key difference between a REIT and a land trust is that the latter has no restrictions on the amount it
must distribute to its unit holders. Land trusts are free to reinvest their money in any way they wish.
A real estate operating company (REOC) is similar to a real estate investment trust (REIT) except that an
REOC can reinvest its earnings into the business rather than distribute them to unit holders the way REITs do.
REOCs are also more flexible than REITs in terms of what types of real estate investments they can make.

Ownership of the corporate entity is divided into partial interests by selling shares to
an investment group. Any specific stock holding represents a percentage of total cor-
porate ownership. For example, if a particular investor owns 250 shares out of 10,000
total shares issued by the corporation, that investor owns 2.5% of the corporation.
This percentage is an ownership share in the corporation, not a percentage of any real
property held by the corporation.
Limited Liability Companies

A limited liability company (LLC) incorporates features of both a corporation and a
partnership. The “limited liability” of an LLC is similar to that of a corporation, in
which the members of the LLC do not risk their personal assets. On the other hand,
an LLC—like a partnership—can function as a pass-through entity with earnings
taxed only at the level of the interest holder, not at the corporate level as well. By
1997, all US states had adopted legislation authorizing the establishment of LLCs.
The owners of a limited liability company are members, rather than shareholders
or partners, and thus are not subject to some of the restrictions imposed on ownership
under a corporate or partnership structure. Unless otherwise specified, management
is generally vested in the members of an LLC in proportion to their contributions of
capital. Members may separate their right to a share of the company profits from the
right to participate in management or to vote on matters affecting the company. These
separated rights can then be assigned to a transferee without disrupting the operation
of the company. The transfer of ownership interests in a limited liability company is
generally simpler than the transfer of shares in a corporation or partnership.
Syndications
Syndications are another means for selling interests or rights in real property. A syndi-
cation creates a private or public partnership to pool funds for the acquisition, develop-
ment, holding, management, or disposition of real estate. Syndications are established
when an individual or group purchases interests in real property for the purpose of
transferring them to a limited partnership, which in turn sells the interests to investors.
At one time, syndications were popular because the investment value of syndi-
cate shares usually included income tax shelter benefits. These investments offered
small income returns during the early years, when the value of the investment was
perceived to rest largely in its income tax benefits (e.g., tax deductions and tax defer-
rals). However, the Tax Reform Act of 1986 significantly reduced the use of real estate
investments as income shelters.
Although syndications usually involve some sort of partnership, they differ from
partnerships insofar as the rights of investors in a syndication are different than the
rights of general or limited partners in a partnership. Syndication arrangements may
be simple in theory, but in practice they are often complex because syndications fre-
quently purchase more than real estate (e.g., management services).
Special Forms of Ownership

In addition to concurrent ownership and ownership by legal entities, there are sev-
eral special forms of ownership that involve a combination of individual and joint
property rights, including
• Condominium ownership

• Cooperative ownership
• Timesharing
Condominium Ownership
A condominium is a form of ownership of separate units or portions of multiunit
buildings with undivided ownership of common elements. While residential and
retail properties were once the main types of property held in condominium owner-
ship, condominium interests can now be found in most property types, including
hotels, offices, industrial buildings, retail structures, and even garden plots, marina
slips, and undeveloped land where the access roads and utilities are the common
property. In land condominiums—which are land subdivisions in all but name—the
use of the condominium form of ownership allows the declarant to avoid certain
zoning restrictions pertaining to the subdivided lots. For example, the floor area ratio
(FAR) limits that would have applied to each lot in a traditional subdivision of indi-
vidually owned lots instead would apply only to the undivided parcel. In real estate
markets outside the United States, variants of condominium ownership can be the
most common type of ownership. For example, in Colombia condominium owner-
ship is widely used in residential and commercial development.3
A condominium unit is a separate ownership interest, and title is held by an indi-
vidual owner. The unit may be separately leased, sold, or mortgaged. While there are
various forms in a traditional condominium, the owner holds title to an individual
unit and an undivided partial interest in the common areas of the total condominium
project—e.g., the land, the public portions of the building, the foundation, the outer
walls, and the spaces provided for parking and recreation. Thus, the unit owner pos-
sesses a three-dimensional space within the outer walls, roof or ceiling, and floors
and has an undivided interest in common areas along with the other owners. The
master deed or condominium plan for a condominium typically describes the bound-
aries of the property using the length and width of the space just like a deed for a
conventional property, but the condominium master deed also describes the property
in three dimensions (i.e., the vertical boundaries of the unit). A condominium owner
usually receives a short deed referring to the master deed and identifying the indi-
vidual unit by a unit number.
Limited common elements also exist in certain condominium projects. In this
arrangement, certain common elements, such as parking stalls, storage units, or plots
of surrounding land, are reserved for the use of some but not all of the condominium
owners. The owners of units in a condominium project usually form an association
to manage the project in accordance with adopted bylaws. The expenses of manage-
ment and maintenance are divided proportionately among the owners, who pay a
monthly fee.
The master deed or other legal arrangement usually provides for the establish-
ment of a condominium owners association, and the bylaws of that organization gen-
erally set forth any rules such as the responsibilities of unit owners for assessments
and maintenance fees and any restrictions such as restrictions on pets or color choices.
Condominium development can be sensitive to real estate market fundamen-
tals. For example, consider a condominium project in which a substantial number of
units remain unsold and the owners of some other units are experiencing bankruptcy
3. Howard C. Gelbtuch with Eunice H. Park, Real Estate Valuation in Global Markets, 2nd ed. (Chicago: Appraisal Institute, 2011), 109.

or foreclosure. If the developer is no longer in business, the few solvent owners of
units must assume financial responsibility for the upkeep of the common areas even
though they were only responsible for a fraction of these expenses under their initial
homeowner agreements. Situations like this are common in some overbuilt areas, and
they are one reason that the recovery of condominium and townhouse developments
can lag behind the recovery of the market for detached single-unit homes.
Cooperative Ownership
For a cooperatively owned apartment property, a stock corporation is organized, and
that corporation acquires title to an apartment building, prices the various apart-
ments, and issues an authorized number of shares at a specified par value. Individual
owners purchase shares of stock, with the price per unit determining the number of
shares that an occupant of an apartment unit must purchase. In cooperative owner-
ship—commonly shortened to co-op—each owner of stock receives a proprietary
lease on a specific apartment and is obligated to make a monthly payment that repre-
sents the proportionate share of operating expenses and debt service on the underly-
ing mortgage, which is paid by the corporation. The lease obligates the occupant to
pay a monthly maintenance fee, which may be adjusted at times by the corporation’s
board of directors. The fee covers the expenses of management, operations, and
maintenance of public areas. Because the shareholders can vote their shares in elect-
ing directors, they have some control over property conditions.
An alternative method for financing cooperatives has emerged in some areas. In
the past, cooperative corporations arranged mortgages on entire apartment prop-
erties. Cooperative shareholders had to fund their purchases with 100% equity or
borrow the money from commercial banks using short-term, personal notes. Now,
however, a cooperative corporation can arrange a mortgage on the total property, and
individual apartment shareholders can mortgage their stock for a portion of its value.
Historically, the complicated financing structure of cooperatively owned prop-
erty—with the owner of a cooperative apartment typically paying both for a loan
on the individual unit and for a share of the blanket mortgage on the entire build-
ing—has been seen as a disadvantage of cooperative ownership as compared to
condominium ownership. Buyers of units in a cooperatively owned building would
have to take into account the greater risk inherent in the underlying mortgage for the
entire property. Co-op restrictions may not allow subletting, which would be seen
as a negative influence on value by someone who viewed the unit as an investment
and might want to rent out the unit based on the income potential of similar units in
the market. The perceived social exclusivity of a cooperative building, where a board
of directors often has more influence on whether a unit can be bought and sold than
a condominium association does, and the greater power of a co-op board to punish
rule-breakers can be both disadvantageous or advantageous depending on the per-
spective of particular buyers and sellers.
Timesharing
Timesharing involves the sale of limited ownership interests in, or rights to use and
occupy, residential apartments or hotel rooms. There are four general categories of
timeshare interests, and it is imperative that appraisers distinguish between them
when valuing timeshare projects or analyzing timeshare comparables. There are two
types of deeded interests in timeshares and two types of non-deeded interests.

The first category of deeded interests involves designated periods of time on
a recurring basis at specific timeshare resorts. The second type of deeded interest
involves a “floating” period of time during a specific portion of the entire year at a
specific resort or group of resorts. Non-deeded interests can be right-to-use interests
for a specific period of time at a specific resort or network of resorts, or, alternatively,
can be “points only” interests that can be used at various resorts in a proprietary
network or in a vacation club system. In the first form of deeded interests, known
as fee timesharing, the purchaser of the deeded timeshare interest obtains a deed that
conveys title to a unit for a specific part of a year, thereby limiting the ownership. The
purchaser has the right to sell, lease, or bequeath the timeshare interest. The interest
can be mortgaged, and title can be recorded. The seller of a non-deeded timeshare in-
terest does not convey a legal title in the property. Typically, a purchaser receives only
the right to use a timeshare unit and related premises or to use the “points” involved
in the purchase. In many projects, fifty one-week intervals are created. The remaining
two weeks of each year are reserved for maintenance and major repairs.
Deeded timeshare interests can be further classified as timeshare ownership or
interval ownership. In timeshare ownership a purchaser receives a deed to a particu-
lar unit as a tenant in common. Each purchaser agrees to use the unit only during
the time period stipulated in the deed. In interval ownership, the ownership period
may only last for the duration of the project. At the end of the specified time period,
the ownership reverts to the interval owners as tenants in common. They then have
the option of selling the property and dividing the proceeds, or continuing as tenants
in common and renewing the interval estate. Timeshare owners and interval own-
ers pay operating expenses, including a proportionate share of taxes, insurance, and
other costs, and a fee for common area maintenance (CAM) and management.
Non-deeded timeshare interests can also be put into various subcategories such
as a leasehold interest, a vacation license, or a club membership.4 The leasehold inter-
est type of timesharing is essentially a prepaid lease arrangement. A vacation license
involves the transfer of a license from the developer to the purchaser, giving the latter
the right to use a given type of unit for specified time periods over the life of the va-
cation license contract. In the club membership form of ownership, timeshare patrons
purchase membership for a specified number of years in a club that owns, leases, or
operates the timeshare property. The purchaser receives the right to use a particular
type of unit for a specified period during each year of membership.
There is a two-tiered market in the timeshare industry:
1. An original (primary) marketplace consisting of sales by resort developers and
owners to individual buyers
2. The resale (secondary) marketplace consisting of resales by individuals who have
purchased from the resort developers (or in the secondary marketplace)
The market participants in each market and the process by which timeshare interests
are sold—as well as the prices—are quite different in each of those markets. Ap-
praisers must take care to use only sale prices from the particular market in which
the appraised interest would be sold. For example, it would typically be improper to
use sales from the primary resort developer marketplace to value a timeshare inter-
est that is reselling in the secondary market. Purchases from resort developers in the
4. Under the laws of some states, vacation licenses and club memberships are not considered interests in real property but rather personal property.

primary marketplace typically include concession and financing packages such as
interest-free deferred payments, cash or resort credits, packages of points in a vaca-
tion club system, or other inducements that cannot be transferred or resold in the
secondary marketplace.

Scope of Work 8
In the valuation process, the identification of the assignment elements leads directly
into the determination of the scope of work of an assignment, i.e., the type and extent
of research needed to solve an appraisal problem. Professional valuation standards
place the responsibility for determining the appropriate scope of work in an apprais-
al assignment squarely on the shoulders of the appraiser.1 The scope of work for an
assignment is acceptable if it leads to credible assignment results, is consistent with
the expectations of parties who are regularly intended users for similar assignments,
and is consistent with what the actions of an appraiser’s peers would be in the same
or a similar assignment.
Developing a scope of work is a bottom-up process: an appraiser starts with
the valuation practices that are essential in all assignments and then considers the
applicability of the professional standards and practices to the problem at hand. The
ideal solution is arrived at not by reducing a standardized procedure to meet specific
required components, but rather by building a logical framework for the assignment
from the ground up.
In effect, scope of work provides appraisers with the flexibility to perform the
level of analysis that is appropriate for a specific appraisal assignment. However,
with that flexibility comes the responsibility to determine what the appropriate level
of analysis is and to communicate that to the client. As a result, ready-made solu-
tions are not appropriate for all assignments. Instead,
an appraisal in which an appraiser demonstrates a
clear understanding of the problem to be solved for the
scope of work
client and provides the precise amount of analysis and
The type and extent of
detail desired will likely be seen as the most credible. In research and analyses in an
fact, the demand from clients for appraisals tailored to appraisal or appraisal review
their specific needs prompted the shift in the profession assignment.
from a one-size-fits-all process to the current emphasis
1. See also Stephanie Coleman, Scope of Work, 2nd ed. (Chicago: Appraisal Institute, 2016).
on a scope of work tailored to the particular assignment. The valuation profession is
likely to follow other professions in increasing the customization of services to meet
specific needs in the marketplace, which will make the determination of scope of
work more important than ever.
The development of the

Problem Solving
scope of work of an as- An appraisal assignment is a problem to be solved. In
signment applies to the solving any problem, there are three major steps to the
appraisal review process process:
as well as the valuation
process. The scope of work 1. Identify the problem.
of a review assignment is 2. Determine the solution (i.e., scope of work).
discussed in Chapter 34.
3. Apply the solution.
None of the three steps may be omitted, and each must
be carried out in this logical order.
Identifying the Problem

Seven significant elements of a valuation assignment were discussed in the preced-
ing chapters: client, intended user, intended use, type of opinion, effective date of
opinion, relevant characteristics of the subject property, and assignment conditions.
Identifying these elements is, in effect, the process of identifying the appraisal prob-
lem. Only after the elements of the assignment are understood can an appraiser move
on to the second step, determining the scope of work necessary to solve the problem.
The problems that appraisers are asked to solve can be small or large, simple or
complex. For example, in a typical appraisal for residential mortgage lending, the
problem is relatively straightforward. The client—a lender—needs an independent
opinion of market value from an appraiser as part of the institution’s due diligence
Scope of Work in Valuation Standards

Valuation standards usually provide for the possibility of exceptions from some portion of the standards when
certain conditions are met. Conceptually, scope of work is not about making exceptions, i.e., it focuses on
what an appraiser does to solve the appraisal problem rather than what an appraiser does not do.
Relevant references in the Standards of Valuation Practice include
• SR A-3: Scope of Work (appraisal)
• SR B-3: Scope of Work (review)
• SR C-2(a)(xii) and C-2(b)(x): Sufficient Report Content (scope of work reporting)
Relevant references in the Uniform Standards of Professional Appraisal Practice include
• Scope of Work Rule
• Advisory Opinion 22: Scope of Work in Market Value Appraisal Assignments for Real Property
• Advisory Opinion 28: Scope of Work Decision, Performance, and Disclosure
• Advisory Opinion 29: An Acceptable Scope of Work
In the International Valuation Standards, relevant references include
• General Standards: IVS 101 Scope of Work
Standards clearly require consideration and disclosure of the scope of work in any appraisal or appraisal
review assignment.

before approving (or not approving) a home loan. Contrast this with an appraisal
of vacant land on the edge of a suburban area experiencing an economic downturn;
the land might (or might not) be ready for new development. The client—a property
owner—wants to know if developing a new facility is currently feasible (or when
it will likely be feasible). This problem is more complex. More than one opinion
of value might be necessary in this case: (1) the current market value of the vacant
land and (2) the forecast market value of the improved land at various points in the
future (e.g., upon completion of construction, upon stabilization). As a third example,
consider an appraisal of an existing office building that is the subject of a property tax
dispute. The property itself might not pose a complex problem, but the intended use
of the results of the analysis can complicate the scope of work. The client—the owner
of the office building—wants an appraiser to develop an opinion of the market value
of the property that the client can compare with the assessed value estimated by the
county assessor. Later, the client’s attorney may ask the appraiser to testify at a hear-
ing, where the appraiser’s analysis and opinion of value could be under the scrutiny
of an opposing party.
In the examples above, all the information collected and analyzed in an ap-
praiser’s consultation with the client and preliminary investigation of the property
characteristics and assignment conditions helps the appraiser answer the questions
who, what, when, where, and why. An appraiser answers the question how by determin-
ing the scope of work.
Determining the Solution

The scope of work that would solve a particular problem must not only meet the
expectations of the client and parties who are regularly intended users of similar
assignments, but also must be consistent with the actions of an appraiser’s peers in
similar situations. Determining the scope of work that meets the expectations of the
client and other intended users fulfills the business needs of both the appraiser and
the client, i.e., the appraiser is providing the client with the service that the client
needs. An understanding of what accepted techniques and data other appraisers
would consider as the basis of an appropriate solution to the client’s problem is a pre-
requisite for professional competency.
Tables 8.1, 8.2, and 8.3 illustrate the types of activities conducted in valuation
assignments that fall along the spectrum from least-intensive scope of work to most-
intensive scope of work. Similar analyses can be performed on any step in the valua-
tion process to help determine the appropriate scope of work for a particular activity.
In the appraisal for a residential mortgage loan described earlier, the problem
was identified as developing an opinion of the market value of a residential property
for use in a lending institution’s decision making. For this assignment, the scope of
work for the application of the sales comparison approach would likely be relatively
intensive, with supportable adjustments to recent comparable data providing the
most credible indication of market value. The typical client for this type of assign-
ment might not expect an appraiser to apply the cost approach in this assignment,
and the appraiser’s peers would likely agree, as long as the reason for omitting the
approach is explained in the appraisal report. Similarly, the income capitalization ap-
proach would likely be of little relevance in an appraisal of owner-occupied housing.
As a result, the scope of work for the cost and income capitalization approaches in
Scope of Work 77
Table 8.1 Identification of Relevant Real Property Characteristics
Process Physical Legal (e.g., zoning) Economic (e.g., actual gross income)
Less Intensive No site visit* No research* Obtain from owner*
Drive-by visit* Examine zoning maps* Read leases
Drive-by, exterior-only* Talk to planning/zoning • Read leases
site visit with exterior department* • Verify with management company
measurements
More Intensive Site visit including • Talk to planning/zoning • Read leases
examination of interior department • Verify with management company
with interior • Obtain and read zoning and tenants
measuretments ordinance
* Special/extraordinary assumptions will need to be stated about information taken to be true when it is uncertain.
Table 8.2 Application of the Three Approaches to Value

Process Cost Approach Sales Comparison Approach Income Capitalization Approach
Less Intensive Not necessary, omitted Not necessary, omitted Not necessary, omitted
• Land valuation via • Comparable data from files • Comparable rental, expense, and
extraction • No adjustments to vacancy data from files
• Comparable cost comparables in analysis • Capitalization rates from readily
data from readily available sources
available sources
Verified comparable Comparable data from Comparable data, including
cost data from cost readily available sources, capitalization rates from readily
manual confirmed with one or available sources, confirmed with
more parties to the one or more parties to the
transaction transaction
More Intensive • Land valuation via • Thorough search of all • Thorough search of all available
sales comparison available data sources data sources
approach with • Confirmation with one or • Confirmation with one or
complete verification more parties to the more parties to the
of sales data transaction transaction
• Comparable cost • Adjustments via paired • Local vacancy survey
data obtained from sales analysis
local contractors
Table 8.3 Development of a Highest and Best Use Opinion (Market Value Appraisal)
Process
Less Intensive Inferred; based on readily observed evidence, such as surrounding land uses, age and condition
of existing improvements, and known market demand for property type*
Application of four tests (physically possible, legally permissible, financially feasible, maximally
productive) but based on readily observed evidence*
Application of four tests (physically possible, legally permissible, financially feasible, maximally
productive) with research into each factor, testing for feasibility
More Intensive Application of four tests (physically possible, legally permissible, financially feasible, maximally
productive) with complete market analysis and feasibility study
* Special/extraordinary assumptions may need to be stated about information taken to be true when it is uncertain.
Source: Stephanie Coleman, Scope of Work, 2nd ed. (Chicago: Appraisal Institute, 2016), 56-57.

this assignment would likely be on the least-intensive side of the spectrum or per-
haps omitted altogether as unnecessary, assuming such omissions do not negatively
impact the credibility of the valuation.
In contrast, consider an assignment to appraise proposed improvements on a site
that is currently vacant. This assignment might involve a feasibility study of potential
development on the subject site, with opinions of market value needed at different
points along the development timeline. The analysis of market conditions and the
highest and best use of the subject site would undoubtedly be at the more-intensive
end of the spectrum for this assignment. This assignment would call for extraordi-
nary assumptions relating to the completion of construction at a future date and the
stabilization of occupancy within the as-yet-unbuilt improvements at some other
date in the future. Current and future market conditions to support rent projections
and the absorption of new space would likely require significant research and market
support to be credible, so the application of the income capitalization approach in
this assignment would probably be toward the most-intensive end of the scale.
Another example would be an appraisal of an existing office building for a
property tax appeal. To remain an unbiased professional, an appraiser cannot let the
nature of the assignment dictate the results. In this situation, the intended use of the
appraisal may legitimately influence the scope of work in certain ways. For example,
data collection and verification might need to be more intensive because the apprais-
al may be scrutinized in a potentially contentious hearing. The representatives of the
assessor’s office would likely use any errors or inconsistencies in the data supporting
the appraiser’s opinion of value to impugn his or her testimony.
Applying the Solution

An appraiser who has determined the scope of work has a plan in place to complete
the assignment. However, the initial determination of the scope of work of the as-
signment may not be what an appraiser must ultimately apply to solve the problem.
As an appraiser gathers and analyzes data and comes to conclusions, the scope of
work necessary to arrive at a solution to the client’s problem may change. The appli-
cation of the solution to the problem is an ongoing process of revisiting the scope of
work as new information comes to light.
In some cases, more work than is initially anticipated may be required for an
appraisal to be credible. Suppose the appraiser of the vacant land discussed earlier
discovers at the time of inspection that the parcel benefits from exquisite views of the
ocean, far superior to the views afforded by any other parcel in the area and far su-
perior to what the appraiser expected. The appraiser’s scope of work will now need
to be expanded to include a careful analysis of the impact of the views on the subject
property. The appraiser may need to analyze less recent sales or sales in other areas
to properly evaluate the effect on value of the views.
Disclosure of Scope of Work

The appraisal must clearly disclose the scope of work that was applied to develop the
opinions and conclusions reported to the client. The disclosure of the scope of work
in the appraisal report must be sufficient so that the intended users understand the
scope of work that was performed. The scope of work discussion should address the
following topic areas:
Scope of Work 79
• The extent to which the property was identified
• The extent to which the property was inspected
• The type and extent of data researched
• The type and extent of analyses applied
The scope of work discussion must address what was done and what was not
done if an intended user might expect that a certain component of the valuation pro-
cess had been performed. In an appraisal assignment, if any of the three approaches
to value was excluded, the exclusion must be explained. In addition, if one or more
persons provided significant real property appraisal assistance but did not sign the
report, their contributions must be explained in the appraisal report and they must
be named in the report certification.
In the appraisal of the house for lending purposes, the client would most likely
expect (and perhaps require) the appraisal report to be submitted on a standardized
form like the Uniform Residential Appraisal Report (Fannie Mae Form 1004/Fred-
die Mac Form 70). The appraiser would then have to determine whether the scope of
work discussion included on the form provided enough detail to disclose the scope
of work necessary to develop a credible appraisal and, if not, supplement the form.
The appraisal of the office building would likely need to be communicated in an ex-
tensively documented narrative report so that the appraiser would be able to disclose
what activities were performed in applying each of the approaches to value.
A separate section devoted to the scope of work in a written report provides the
reader of the report with a clear picture of what the appraiser did, but the disclo-
sure of the scope of work can be handled at various
relevant points along the way, e.g., disclosure of the
scope of work for the application of the sales compari-
Avoid “boilerplate” scope son approach in the section of the report covering that
of work discussions in ap- approach. And a combination of these two methods
praisal reports. The scope
of work actually performed works as well, providing a general disclosure of the
in the particular assignment scope of work in the introductory section of the report
should be reported. and more detailed discussions of scope of work at ap-
propriate points later in the report.

Data Collection 9
In real estate appraisal, the quality and quantity of information available for analysis
are as important as the methods and techniques used to process the data and com-
plete the assignment. Therefore, the ability to determine the amount and type of data
needed to answer the client’s question, to distinguish between different kinds of data,
to research reliable data sources, and to manage information is essential to effective
appraisal practice.
Identifying comparable properties and collecting other market data for use in the
valuation process was once a time-consuming and expensive process. The growth
of data vendors and the increasing accessibility of market data through electronic
sources have shifted the historical emphasis of appraisal practice from data collec-
tion to data analysis. Still, collecting accurate, reliable data remains an essential task
because the conclusions of the analyses of appraisers are only as good as the data that
supports those conclusions.
The process of finding, filtering, and organizing data has been improved ex-
ponentially by the internet and the wide availability of sophisticated information
technology. To that end, appraisers need new skills, refined judgment, and improved
research techniques to gather and manage information efficiently in the rapidly
evolving data universe.
Data Fundamentals
Data is increasingly omnipresent, almost overwhelming. In early 2012, it was esti-
mated that 90% of the world’s data had been generated in the preceding two years,
with little expectation of the rate slowing. However, data is formatted and cataloged
primarily for use by the system that generated it. The challenge for appraisers in
the twenty-first century is no longer simply finding data (although in declining or
inactive real estate markets, transactional data can still be scarce) and passing that
data along to their clients. Rather, filtering and reconciling relevant and meaning-
ful information from the glut of growing sources and using that data to support the
conclusions of the appraisal analysis are more important than ever. Today clients are
more sophisticated and demand more detailed evidence that an appraiser previously
identified and analyzed what was considered the best and most relevant data.
In most appraisal analyses, appraisers will need to gather and examine more
than one type of data. The description of the architectural style of the subject prop-
erty, an appraiser’s judgment of the current condition of the improvements, and
historical and forecast rent levels of competitive properties in the subject property’s
market area are all examples of the wide variety of information that appraisers rou-
tinely collect. The types of data needed in any appraisal assignment can be as diverse
as the many influences on value in the marketplace.
An important distinction can be made between data that is available and ap-
plicable to the analysis in enough detail for an appraiser to properly formulate and
support an opinion of value and the data provided to a client in a report. Successful
analysis depends on the depth, quantity, and quality of the data that an appraiser can
synthesize. By contrast, the appraisal reporting process is concerned with communi-
cating the specific conclusions of the analysis to the client. An appraiser makes pre-
liminary decisions about the relevance and usefulness of different types of data in a
given assignment as part of the development of the scope of work of the assignment.
Data Collection in the Scope of Work

The scope of work of an appraisal assignment includes consideration of the extent
of the data collection process. For a complex assignment, the data collection process
may be much more difficult than for a straightforward assignment in which the
macro-level data about the market and the micro-level data about the subject and
comparable properties are readily available from standard sources.
The data collection process can differ from state to state. Many states have open
property records available to appraisers, but others are nondisclosure states where
sales data can only be confirmed with the actual parties to the sale. Also, govern-
ment programs can require different levels of data collection and documentation.
For example, certain specific data is required to complete the Uniform Residential
Appraisal Report (URAR) for a government-backed loan program.
Before beginning the process of data collection, an appraiser determines which
types of data will be needed to answer the client’s question about value. Thus, the na-
ture of the data collected is greatly dependent on the scope of the assignment, the prop-
erty type being appraised, and the market conditions within the market area identified
by the appraiser. In the appraisal report, an appraiser communicates the type of data
chosen for analysis to the client with the analyses. An appraiser may also communicate
what data was not chosen for analysis and the reasons for the exclusion of any investi-
gation, information, method, or technique that could be viewed as potentially relevant
to the assignment by the client, another intended user, or the appraiser’s peers.
Different types of data are useful in the different portions of the valuation
process. First, an appraiser may collect macro-level data on the demographics of the
market area and competitive supply and demand data on competitive properties to
perform market analysis. Then additional data is gathered for highest and best use
analysis, which requires micro-level data such as information on the physical charac-
teristics of the subject property, zoning restrictions, and the income anticipated from
alternative uses. The analysis undertaken in the application of the three approaches

to value generally requires physical information about the subject for the develop-
ment of the cost, income capitalization, and sales comparison approaches. This also
makes comparisons with comparable properties more valid and reliable.
Understanding the content and sources of macro-level and micro-level data fa-
cilitates data analysis in valuation and consulting assignments. Before analyzing the
data, however, an appraiser should organize all the data accumulated in the investi-
gation. Market data grids, like the cost survey worksheet used in the cost approach,
the adjustment grid used in the sales comparison approach, and the reconstructed
operating statement used in the income capitalization approach, are carefully pre-
pared spreadsheets that provide a tabular representation of market data organized
into useful, measurable categories (see Table 9.1). If the information to be analyzed
is complex, an appraiser may need to design several different types of market data
grids to isolate and study specific data.
Once the data has been collected and organized, it can be analyzed to solve
the problem posed by the appraisal assignment. Market analysis and highest and
best use analysis are the most obvious forms of data analysis, but each of the three
approaches to value is also a form of analysis that relies on market data gathered
through an inferred or fundamental market analysis and presented as support for the
value conclusions derived. The validity of each approach’s conclusions and, ultimate-
ly, the final opinion of market value depend on how well the market data presented
supports those conclusions.
In the appraisal report, the analysis must answer the implied question, “Why is
this information relevant?” The analysis should tie the economic and financial data to
the real estate market in general and to the particular market in which the real estate
being appraised is located. For example, if an appraiser’s economic data shows that
the rate of employment growth is decreasing, then the appraisal report should illus-
trate how this will affect the market in general in addition to the type of property and
individual property being appraised in particular.
Table 9.1 Sample Market Data Grid

Sales Adjustment Grid—Subdivision Lot Sales
Sale 1 Sale 2 Sale 3
Unadjusted price/lot $65,000 $55,000 $60,000
Property rights conveyed × 1.00 × 1.00 × 1.00
Intermediate adjusted price $65,000 $55,000 $60,000
Financing terms × 1.00 × 0.95 × 1.00
Conditions of sale × 1.00 × 1.10 × 1.00
Market conditions (-2%/mo.) × 0.86 × 0.96 × 0.88
Location adjustment ($4,000) − −
Average lot size adjustment ($4,000) − ($4,000)
Lot premiums adjustment − − −
Number of lots adjustment − ($7,000) −
Subject by comparison $47,900 $48,176 $48,800
Data Collection 83
How Much Data Is Enough?
Most appraisal assignments begin without full knowledge of how much data is needed. One school of
thought would suggest that appraisers collect only as much data as needed to achieve the desired results.
Subscribing to this theory requires an appraiser to be clear on that objective. In real estate appraisal, the
objective is most commonly credible assignment results, and while appraisers understand the concept, at the
beginning of an assignment they can be unclear about what will be needed to achieve that outcome.
Determining the appropriate amount of data for an assignment hinges on the concept of credible as-
signment results. Professional standards make it clear that credibility is always measured in the context of
intended use. For example, the Scope of Work Rule of USPAP requires that an appraiser must “gather and
analyze information about those assignment elements that are necessary to properly identify the appraisal,
or appraisal review problem to be solved.” Likewise, Standard 1 requires an appraiser to “correctly complete
research and analyses necessary to produce a credible appraisal.” Ultimately, the intended use of the assign-
ment results is the key driver for nearly every decision an appraiser will make in the course of the assign-
ment, which includes deciding how much data is enough.
Gathering data is not a one-time event. No one foray into the available sources will satisfy all the data
requirements for a typical assignment. In many cases, a certain amount of basic data will be furnished by the
client at the beginning of the assignment. Then the appraiser will perform research and gather initial data to
form the foundation of the assignment. At this point, the appraiser still may not know where the assignment
is ultimately going to lead, so the first round of data acquisition might have the primary benefit of informing
subsequent research.
Appraisers should pause to assess the results of their research as they move from one round of research
to another so they can understand the strengths and weaknesses of the data already in hand. At each phase
of data research, appraisers should be asking questions such as
• What decisions are we trying to make with the data?
• What is the minimum amount of data needed to support those decisions?
• How much uncertainty in the resulting analysis of that data is acceptable?
• How much might the addition of one or two data points to an existing population of data change the results?
The more precision required in the analysis, the more likely that additional data will result in more reliable
results. To make inferences about trends and patterns from data, it is almost always best to use the largest
populations of data that can be assembled practically. However, an appraiser needs to balance the amount
of work required to acquire additional data with the probable benefit to the analysis of that data.
The ultimate determination of how much data is enough becomes self-evident when an appraiser con-
cludes an assignment with the confidence that the client, intended users of the assignment results, and the
appraiser’s peers will view the work as competently and professionally prepared and worthy of belief.
Data Sampling
Appraisers rarely have access to all available information for use in their analyses.
Even when an appraiser has conducted extensive research, sample information fre-
quently must be used. Therefore, the principles and implications of sampling should
be understood.
Appraisers frequently must deal with incomplete information. Research involves
the collection of both specific data and sample data for analytical purposes. The data
used by appraisers is seldom a random sample. To establish a framework for select-
ing and drawing a random sampling, strict requirements must be met. More often,
appraisers deal with judgment samples, i.e., sample data that is selected on the basis
of personal judgment and is thought to constitute a representative group. While
certain statistical tests used with random samples cannot be applied to judgment
samples, in many circumstances judgment samples can produce superior results. For
example, data selected from five shopping centers by an experienced analyst may

be more comparable to the subject shopping center than a random sampling of data
from a broader array of shopping centers.
The use of sample data has both strengths and weaknesses:
Strengths Weaknesses
• Samples are generally less expensive and • Sampling must be conducted carefully, and
more readily obtained than complete data. the data must be properly interpreted. If this
• Selected samples are sometimes more is not done, the results can be inaccurate and
indicative than a broader survey. misleading, cost more than they are worth,
• Samples are easily tabulated, lend themselves and be less reliable than they appear.
to cross-referencing, and provide a foundation • Sampling requires special training and
for statistical inference, including probability understanding.
studies. • Many people misunderstand or mistrust
• Often samples may be the only source of samples for a variety of reasons.
data available.
Whether or not an appraiser conducts formal sampling, the extent to which

sample data has been used should be considered in the analytical process. The risks
associated with identified sample data and the uncertainties associated with other
potential data must be considered.
Data samples may be particularly important when other data is scarce or when
the available data is less applicable due to market changes. Sampling may be the only
way to obtain some types of data. Samples are particularly important in
• Quantifying market demand
• Defining market characteristics
• Identifying market attitudes, perceptions, and motivations
• Analyzing market behavior
• Interpreting market activities and intentions
Data Standards
As a rule, good quality data makes good analysis possible. The availability of stan-
dardized data makes more robust analysis possible and enhances research opportu-
nities in a data-rich real estate environment. Data standards are essential for sharing
quality data and ensuring that the data can be put to various uses by the many users
of data within the broader real estate community. Furthermore, mundane tasks
relating to the standardization of data sets are easily handled using the XML format
that has become a de facto internet standard for passing data between systems. After
industry standards organizations agree on semantic definitions and policies for their
application, XML allows those definitions to become a common representation of the
same data from different systems.
The standardization of property and transaction data across heterogeneous real
estate markets and their respective information systems has lagged behind the imple-
mentation of data standards in many other industries. In recent years, the clients of
appraisers have spearheaded the movement toward uniform data standards by de-
manding more consistency, efficiency, and transparency within the appraisal process.
For example, in 2011 residential appraisers had to adapt to the new, standardized
reporting requirements of the Uniform Appraisal Dataset (UAD), which was intro-
duced for use in appraisals performed for conventional mortgage loans that will be
sold to government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie
Data Collection 85
Mac. These requirements have also been adopted by the Federal Housing Adminis-
tration (FHA) and the Veterans Administration (VA).
Although the GSEs have had long-established appraisal policies and requirements,
the responsibility for ensuring compliance rested almost entirely with the loan seller
(i.e., the lender). Upon delivery of a mortgage loan to either GSE, the lender “repre-
sented and warranted” to Fannie Mae or Freddie Mac that the lender had manufac-
tured the loan in accordance with the respective GSE’s requirements. However, almost
no information about the collateral for that loan was transmitted—only the borrower
name, property address, and loan-to-value ratio were delivered with the loan pack-
age. Under the “rep and warrant” model, if the loan subsequently went into default,
Fannie Mae or Freddie Mac would then receive access to the full loan file for investiga-
tion. If it was determined at that point that the appraisal was faulty, the lender might
be forced to buy back the loan from Fannie Mae or Freddie Mac and undertake the
foreclosure process itself. In effect, the GSEs did not have access to any appraisal data
at loan origination, and they only received appraisal data on defaulted loans.
Following the housing crisis in 2007, Fannie Mae began developing a new elec-
tronic appraisal delivery system that would require lenders to deliver the entire
appraisal report in electronic form to Fannie Mae before the loan could be sold. When
the Federal Housing Finance Agency became the conservator to both Fannie Mae and
Freddie Mac, a larger data standards initiative for both GSEs was developed that led to
the implementation of the Uniform Collateral Data Portal and the UAD requirements.
Two major standards groups have been involved in the development and dis-
semination of broader appraisal data standards predating the lending crisis that
spurred the implementation of the UAD:
• The Mortgage Industry Standards Maintenance Organization (MISMO)
• OSCRE International (formerly the Open Standards Consortium for Real Estate)
The mortgage industry, an important driver in the broader real estate industry, has
been working toward data standardization through the Mortgage Industry Standards
Maintenance Organization, formed in 1999 as a nonprofit subsidiary of the Mortgage
Bankers Association. In late 2009, the GSEs selected the MISMO Version 2.6 Valuation
Response XML format as the basis for the UAD. The Open Standards Consortium for
Real Estate brings together data standards from every sector of real estate. OSCRE
International is different from MISMO in that MISMO’s core focus is data standards
specific to mortgage-related and real property reporting information, whereas OSCRE
International goes beyond data standards into business process standards. MISMO
and OSCRE International are working to establish common data terms so that,
throughout the life cycle of a building, all parties are able to use terms consistently.
The state of data standards continues to mature with a primary goal of allow-
ing for more appraisal content (i.e., property, improvement, and site data) to be
addressed in a standard structure. The forthcoming MISMO Reference Model is
expected to accommodate private appraisals, jumbo lending, GSEs, and government
appraisals. While the current Version 2.6 of the MISMO Reference Model is centered
on forms, the forthcoming Version 3.5 is expected to allow for more flexibility.
The release of Version 3.5 of the MISMO Reference Model is expected to be a sig-
nificant milestone. GSEs plan to help appraisal software vendors make their software
more comprehensive and normalize the existing boilerplate language to be more

flexible to cover all intended uses. HUD/FHA and Fannie Mae are working with
appraisers to develop a more secure appraiser signature and to prevent signature
tampering. The UAD and appraisal forms are currently being redesigned.
Also, the Appraisal Institute has developed the Property Use Classification Sys-
tem (PUCS), a uniform classification system for the potential uses of real estate. PUCS
supports a wide range of applications throughout the real estate industry and global
economy, including software programs and database management systems used by
real estate appraisers and appraisal firms.1 National firms are also currently pursuing
efforts to create their own databases to compete with CoStar, which is currently the
dominant data source for certain property types in certain market areas.
Fannie Mae and Freddie Mac currently employ the Uniform Collaborative Data
Portal (UCDP), through which lenders electronically submit residential appraisal
reports for conventional mortgages. Using the UCDP, lenders can upload appraisal
data and view edits and submission details.
Types of Data Used in Real Estate Appraisal

Appraisers gathers data directly (primary data) and use data that has been gathered
by outside sources (secondary data). The data that appraisers use in the valuation
process can be characterized in two ways related to the function of the data:
• Macro-level data
• Micro-level data
Macro-level data consists of information about the social, economic, governmental,
and environmental forces that affect property value in broad terms. This information
is part of the background knowledge that appraisers bring to their practices. In con-
trast, micro-level data includes details about the specific property being appraised,
sales and lease transactions of comparable properties, and local market characteris-
tics relevant to the analysis of the subject property.
Macro-Level Data
An appraiser working in a specific market on a daily basis will often have general
data on file. All macro-level data is ultimately understood in terms of how it affects
the economic climate in which real property transactions occur. Macro-level data is
most frequently used in the analysis of a region or city and to a lesser degree in the
analysis of a smaller market area. In analyzing macro-level data, appraisers observe
the operation of appraisal principles by studying the interaction of the four forces
that affect an area’s property values. Although the four forces provide convenient
categories for examining macro-level data, it is the interaction of those forces that cre-
ates trends and ultimately influences property value.
Economic Trends
Appraisers must recognize and understand the economic trends that affect the value
of real property. It is not enough to know that economic changes have occurred. The
probable direction, extent, impact, and cause of these changes must also be studied to
identify and forecast trends.
1. PUCS Version 1.0 is available on the “Professional Practice” section of the Appraisal Institute’s website at www.appraisalinstitute.org.
Data Collection 87
The particular trends considered by an appraiser vary with the appraisal prob-
lem and the type of real estate being appraised. (Table 9.2 lists useful economic
indicators appraisers often track to analyze trends in the marketplace.) For example,
to develop an opinion of the market value of a shopping center with the income capi-
talization approach to value, an appraiser must forecast the base rent and overage
rent under a percentage lease.2 The shopping center’s total potential gross income
depends on trends in the number of households in the trade area, the income of these
households, and their typical expenditures on the goods and services supplied by
the center’s tenants. The availability of alternative shopping facilities in competitive
markets also must be considered.
The national economy reflects the economic condition of the various geographic
regions of the United States. The economic health of a region depends on the status of
its economic activity, which in turn encompasses the economic activities in individual
areas and communities within the region’s geographic boundaries. Minor disrup-
tions in the economic growth of one community may not appreciably affect the entire
region if the regional and national economies are strong.
The extent to which an appraiser is concerned with the national or regional
economy and the economy of the city or market area depends on the size and type of
property being appraised. For example, a large regional shopping center that serves
a trade area of 500,000 people and an automobile assembly plant that employs 5,000
workers may be more sensitive to the general state of the economy than medical-den-
tal office buildings or retail service operations in suburban residential areas.
In the global economy, the economic well-being of one nation may directly and
indirectly affect other nations. There is much foreign investment in US real estate,
partly because the stability of the US government gives foreign investors some mea-
sure of protection. As a result, political instability in other countries can influence the
demand for, and value of, real estate in the United States.
International economic trends can have significant effects on local economies and
specific real estate markets. For example, the status of the Asian economy can affect the
level of international trade, which in turn has a major impact on the economy of Pacific
Rim port cities (and perhaps the demand for warehouse space). Increasingly, trends in
international financing can influence local real estate markets as well. In the 1980s, using
financing techniques unavailable to American investors, Japanese investors could pay
inflated prices for prestigious properties in Hawaii and California, including most of
the luxury hotel rooms in Hawaii. At the time, real estate appraisers in Hawaii had to
provide two different values reflecting the influence of Japanese investment practices
(often without the benefit of a pro forma statement, lease analysis, or market study) and
traditional US lending practices. The collapse of the Japanese economy, due in part to
bad loans made by Japanese banks, eventually caused prices in the Hawaiian real estate
market to plunge, with Japanese investors losing billions of dollars on their investments.
The state of the national economy is basic to any real estate appraisal. Financial
institutions must compete for funds to lend, not only with one another but also with
money market mutual funds and other investments. Lending rates reflect this ongo-
ing competition, and demand in the market adjusts itself accordingly.
Federal programs and tax policies can affect the value of real estate. The Tax
Reform Act of 1986 eliminated many of the tax advantages of owning property by
2. See Chapter 23 for the definitions of percentage lease, base rent, and overage rent.

Table 9.2 Economic Trends and Useful Economic Indicators
Trends Useful Economic Indicators
International economic trends Changes in:
• Balance of foreign trade
• Rates of foreign exchange
• Commodity price levels
• Wage levels
• Interest rates
• Industrial production levels
• Volume of retail sales
National and regional economic trends Changes in:
• Gross national product
• Gross domestic product
• National income
• The balance of payments to other nations
• Price level indexes
• Interest rates
• Aggregate employment and unemployment statistics
• The number of housing starts and building permits issued
• Other macro-level data
Note: A time series of economic indicators, which describes and measures
changes or movements over a period of time, may reveal fluctuations in
long-term trends and help put current statistics in perspective—i.e., help
determine the current position of the economic cycle.
Local economic trends Changes in:
• Population
• Net household formation
• The diversity of the economic base of the community
• The level and stability of employment
• Wage rates
• Household or family income
Economic trends affecting rural land Changes in:
• Size and complexity of business operations in farming, ranching, timber
harvesting, drilling, or mining
• Level of mechanization or labor intensiveness
• Degree of dependence on government subsidies or government leased land
• Prospective competition from imports
modifying the Accelerated Cost Recovery System, which often allowed a property
to contribute more value as a tax shelter than as an operating business. Along with
modification of Section 1031 of the Internal Revenue Code in 1984, the Tax Reform
Act encouraged “like-kind” exchanges.3 The 1031 exchange program allows a prop-
erty owner to defer capital gains taxes if real property is exchanged for other real
property, within certain limitations as defined in the code. The sale price of a compa-
3. See also Jack P. Friedman and Jack C. Harris, “Tax Reform Encourages 1031 Exchanges: What the Appraiser Should Know About Section 1031,”
The Appraisal Journal (January 1987): 79-93, and Joel Rosenfeld, “Section 1031—Tax-Deferred Exchanges: Real Estate’s Best-Kept Secret for
Tax Relief,” Real Estate Issues (Winter 2000/2001): 12-16.
Data Collection 89
rable property involved in a 1031 exchange may have to be adjusted to reflect the tax
savings of that transaction as compared to a traditional sale.
To understand how national and even international economic trends influence
property value, an appraiser studies how the region and community where the sub-
ject property is located may respond to these trends. The appraiser should examine
the economic structure of the region and the community, the comparative advantages
that each possesses, and the attitudes of local government and residents toward
growth and change. For example, the increasing number of elderly households in
the United States is less significant to property values in Minnesota than to values
in Sunbelt states, which attract more retirees. A community with a no-growth policy
may have substantially different local demographics and economic potential than
one that does not discourage growth.
Regional economies influence local market conditions, but local markets do not
necessarily parallel regional markets. Macroeconomic studies, which are concerned
with broad areas such as cities and regions, are important to understanding real es-
tate and real estate trends. These studies should not be confused with microeconomic
studies, which appraisers perform to evaluate the factors influencing the market
value of a particular real estate parcel. For example, regional trends may suggest an
expected increase in population, but the local data available to the appraiser may in-
dicate that the particular area will not benefit from this trend. While both studies are
important, local trends are more likely to influence property values directly.
Appraisers of rural land should understand the links between the local rural
economy, the regional economic base (agricultural, extractive, or recreational), and
the national economy as well as the encroachment of suburban and urban land uses
on rural land. The subject property should be analyzed in relation to comparable
properties in the immediate agricultural, mining/drilling, or recreational district.
Climatic data can be important in analyzing many rural land uses. A drought in a
grain-producing area or icy conditions in a citrus-growing region can have economic
repercussions beyond disrupting local agricultural production. Tourism and recreation-
al uses of rural land may be affected by the severe weather, and restaurants and hotels
in the region may be forced to raise prices to keep up with the rising cost of food.4
Demographics
The population of a market and its geographic distribution are basic determinants of
the need for real estate. Real estate improvements are provided in response to the de-
mand generated by a population with effective purchasing power. A household—i.e.,
persons who occupy a group of rooms or a single room that constitutes one housing
unit—imposes a basic demand for housing units. In analyzing a local housing mar-
ket, knowledge of trends in the formation of households and household characteris-
tics is crucial. The age, size, income, and other characteristics of households must be
considered to determine the demand for housing.
Two demographic categories generate demand for two different types of space:
1. Households generate demand for space designed to fulfill basic human needs
such as the need for housing and retail and medical services.
2. Employment generates demand for warehouse, industrial, office, and retail space
used in producing goods and services.
4. For further discussion of trends affecting rural property, see Rural Property Valuation (Chicago: Appraisal Institute, 2017).

Often households and employees generate demand for
the same type of space, such as medical research and household
development space. A number of related or
unrelated persons who live in
The demand for commercial and industrial real one housing unit; all the per-
estate is created by a population’s demand for the goods sons occupying a group of
and services to be produced or distributed at these sites. rooms or a single room that
Appraisers must be aware of changes in the character- constitutes one housing unit.
istics and distribution of the population that consumes A single person, a couple, or
more than one family living
goods and services as well as changes in the workforce in a single housing unit may
that produces them. A changing population, coupled make up a household.
with technological advances, can rapidly alter the de-
mand for the services provided by property, which can
affect property value. (See Chapters 15 and 16 for more
discussion of economic base analysis and how appraisers use employment data in esti-
mating supply and demand.)
Government Regulations
To develop an opinion of value properly, an appraiser should understand the govern-
ment regulations and actions that affect the subject property. The comparable proper-
ties selected for analysis should be similar to the subject property in terms of zoning
and other characteristics.
In response to social attitudes, the government establishes land use regulations
and provides public services such as transportation systems and municipal utilities.
Information on zoning, master plans, environmental impacts, transportation systems,
local annexation policies, and other regulations reveals governmental and social at-
titudes toward real estate.
Trends in Building Activity

A property’s value as of a specific date may rise or fall due to fluctuations in building
activity. Housing starts and the construction of commercial and industrial properties
fluctuate in response to business cycles, political events, and the cost and availabil-
ity of financing. These fluctuations follow the long-term trend of new construction.
Short-term fluctuations result in temporary misallocations of supply, which can
depress rents and prices.
The standing stock of housing units at any point in time consists of all units, oc-
cupied and vacant. The stock is continually altered by the construction or conversion
of units in response to developers’ perceptions of the demand for new housing and
by the need to replace existing units.
Many months or even several years may pass between the time a developer
decides to supply units and the time those units enter the market. During this period,
changing conditions may reduce demand, and the units coming on the market may
remain unrented and unsold, thus increasing vacancy rates. Developers may con-
tinue to produce additional units for some time, even in the face of rising vacancies.
Once these excess units are produced, they remain on the market and can depress
rents or prices until demand increases to remove the surplus. When the market
tightens, the supply of units lags behind the increase in demand, resulting in abnor-
mally low vacancy rates and upward pressure on rents and prices. Ultimately, supply
increases as developers respond to increased demand.
Data Collection 91
Fluctuations in the local supply of and demand for real estate (i.e., the life cycle
of the market area) are influenced by regional and national conditions. Therefore,
an appraiser looks for regional and national trends that may indicate a positive or
negative change in property values at the local level. Although all regions may not
experience the same slump in construction, tight monetary policy affects the cost and
availability of mortgage credit and exerts a moderating influence on supply, even in a
rapidly growing region.
Commercial real estate is affected by business conditions and the cost and avail-
ability of financing. Because business firms pass their high financing costs on to con-
sumers, residential construction may be restricted. If the demand for the goods and
services produced or supplied by a business remains strong, the firm can raise prices
and continue to expand even when credit is tight and interest rates are high.
Building Costs
The cost of replacing a building tends to follow the general price levels established over
a long period, but these price levels vary from time to time and from place to place.
Building costs generally decline or stabilize in periods of deflation and increase in peri-
ods of inflation. These costs are affected by material and labor costs, construction tech-
nology, architect and legal fees, financing costs, building codes, and public regulations
such as zoning ordinances, environmental requirements, and subdivision regulations.
Construction costs can alter the quantity and character of demand and, therefore,
the relative prices of property in real estate submarkets. The high cost of new build-
ings increases the demand for, and prices of, existing structures. When the cost of
new structures increases, rehabilitation of existing buildings may become economi-
cally feasible. High building costs increase prices in single-unit residential submar-
kets, which can influence the demand for rental units and their prices. The size and
quality of the dwelling units demanded decrease when building costs increase more
rapidly than purchasing power.
Cost services such as Marshall & Swift/CoreLogic, RS Means, and others are the
primary sources of information on building costs. Appraisers can also collect infor-
mation on building costs from properties that have been developed in a market area.
(Chapter 30 covers building cost estimates in more detail.) Primary data collected by
an appraiser qualifies as micro-level data about a property rather than macro-level
data about the market.
Taxes
Real estate taxes are levied by municipalities (cities, townships, or counties) and tax-
ing districts (i.e., school, fire, water, and local improvement districts). The taxing body
reviews the annual budget to determine the amount of money that needs to be raised.
After revenues from other sources (such as sales or income taxes, state or federal rev-
enue sharing, and interest on investments) are deducted, the remaining funds must
come from property taxes. Assessing officers estimate the value of each parcel of real
estate in the jurisdiction periodically. Real estate taxes are based on the assessed value
of real property, hence the term ad valorem (“according to value”) taxes. The assessed
value of property is normally based on, but not necessarily equivalent to, its market
value. The objective of tax assessment is the equitable distribution of the tax burden
based on real property value, but tax assessors do not attempt to develop opinions of
value for specific parcels of property for use outside of ad valorem taxation.

The ratio of assessed value to market value is called the common level ratio or as-
sessment ratio. (The millage rate refers to the taxes as a percentage of assessed value.) If,
for example, the tax rate is $60 per $1,000 of assessed value and the assessment ratio is
50% of market value, then the annual real estate tax (or effective tax rate) equals 3% of
market value:
$60/$1,000 × 50% = 3%
If assessed value is not based on market value, the formula is modified to reflect the
difference. An effective tax rate can also be calculated by dividing the total amount of
taxes by the market value of the property. Effective tax rates can be used to compare
the tax burden on properties.
In jurisdictions where ad valorem real estate tax assessments have an established
or implied relationship to market value, appraisal services may be required to resolve
tax appeals. In some communities, the trend in real estate taxes is an important
consideration. In cities where public expenditures for schools and municipal services
have increased, a heavy tax burden can cause real estate values to decline. Under
these circumstances, new construction may be discouraged. There may be several
tax districts in a metropolitan area, each with a different policy. Understanding the
system of ad valorem taxation in an area facilitates an appraiser’s analysis of how
taxes affect value.
Different levels of sales taxes, personal property taxes, and taxes on earnings
can also affect the relative desirability of properties. Although these taxes may be
uniform within a state, properties in different states often compete with one another.
To attract new residents and industries, a state may impose taxes that are lower than
those of surrounding states. This may increase demand and enhance property values
in the state relative to values in bordering states. For example, consider two adjacent
states competing for the location of a commercial printing operation. The printing
company owns machinery and equipment worth millions of dollars that may be
taxed as personal property rather than real property, which is more often the case for
industrial operations than for commercial operations. The state that does not have a
personal property tax would be a more attractive location than the state that levies a
personal property tax.
In many areas there are legal provisions that allow a municipality or other gov-
ernment entity to provide assistance to developers who develop certain properties in
tax increment financing, or TIF, districts. The government or developer is allowed to
borrow money for infrastructure improvements and use the future real estate taxes
from the new building(s) to make loan payments. This allows the government to
promote development in areas that are considered disadvantaged or “blighted” and
would not otherwise be developed. The taxes from the new buildings are transferred
to pay off the debt rather than being used for schools, police, parks, and libraries. The
assumption is that if it were not for the TIF incentive, development would not occur.
Financing
The cost of financing includes the interest rate and any points, discounts, equity
participations, or other charges that the lender requires to increase the effective yield
on the loan. Financing depends on the borrower’s ability to qualify for a loan, which
may be determined based on the loan-to-value ratio, the housing expense-to-income
ratio allowed for loans on single-unit homes, and the debt coverage and break-even
Data Collection 93
ratios required for loans on income-producing properties. (These ratios are discussed
in Chapter 25.) The cost and availability of financing typically have an inverse rela-
tionship. High interest rates and other costs usually result in a decrease in the de-
mand for credit and the number of borrowers able to qualify.
The cost and availability of credit for real estate financing influence both the
quantity and quality of the real estate demanded and supplied. When interest rates
are high or mortgage funds are limited, households that would have been in the
home ownership market find that their incomes cannot support the required ex-
penses. Purchases are delayed and smaller homes with fewer amenities are bought.
The cost of financing for land development and construction is reflected in the higher
prices asked for new single-unit homes, and higher prices reduce the quantity of
homes demanded.
The rental market is affected by the demand pressure of households that continue
to rent and by the high cost of supplying new units, which results in part from financ-
ing costs. Occupancy rates and rents rise. Businesses try to pass on their higher occu-
pancy costs to customers by increasing the prices of their products or services. If they
cannot fully recover the increased occupancy cost, the value of these properties will
decline or the quantity of commercial and individual space supplied will be reduced.
In 2019, Fannie Mae and Freddie Mac launched the Uniform Mortgage-Backed
Security (UMBS) in an effort to improve the US housing finance system and to lower
mortgage rates. This initiative unifies Fannie Mae and Freddie Mac’s separate mort-
gage-backed securities and requires the GSEs to align their policies, programs, and
practices that influence cash flows to the holders of these securities. This is expected
to have a far-reaching impact on the mortgage market.
Micro-Level Data
In appraisals, micro-level data is used to determine highest and best use and to make
the specific comparisons and analyses required to develop an opinion of value. The
micro-level data about a subject property provided in land and building descriptions
helps an appraiser select other micro-level data pertaining to comparable sales, rent-
als, construction costs, and specific characteristics of the local market that influence
the value of the subject and comparable properties.
At the conclusion of the analysis of macro-level data, appraisers need to clearly spell
out what this data and analysis means or implies for the specific market and property
being valued. The same process is used in gathering comparable sales data, analyzing
the data, and indicating what it means in relation to an opinion of value for the subject
property. From relevant comparable sales, an appraiser extracts specific sale prices, rent-
al terms, income and expense figures, rates of return on investment, construction costs,
estimates of the economic life of improvements, and rates of depreciation. These figures
are used in calculations that lead to an indication of value for the subject property.
An appraiser needs micro-level data to develop each of the three approaches to
value. An appraiser uses the data to derive adjustments for value-influencing prop-
erty characteristics, to isolate meaningful units of comparison, to develop capitaliza-
tion rates, and to measure depreciation. By extracting relevant data from the largest
quantity of data available, an appraiser develops a sense of the market. This percep-
tion is an essential component of appraisal judgment, which is applied in the valua-
tion process and in the final reconciliation of value indications.

Micro-level data is analyzed through comparison. In each approach to value,
certain items of information must be extracted from market data to make compari-
sons. Micro-level data is studied to determine if these items are present or absent and
if they can be used to make reliable comparisons with the subject property. This sort
of data can include information about properties that have sold as well as properties
that have not sold or are under contract for sale but have not yet closed. If, for ex-
ample, the subject property is an apartment building, an appraiser could use sales of
other apartment buildings to support adjustments for changes in market conditions,
locational differences, or the contribution of various physical characteristics. Apart-
ment buildings that have not sold can also be used to obtain information on rental
rates and expenses.
An appraiser’s analysis of the highest and best use of the land as though vacant
and the property as improved determines what comparable micro-level data is col-
lected and analyzed. The comparable properties should have the same or a similar
highest and best use as the subject property. The nature and amount of research
needed for a specific assignment depend on the property type, the purpose of the
appraisal, and the complexity of the required analysis—in other words, the scope of
work of the assignment.
Of particular significance to the analysis are the supply of competitive properties,
the future demand for the property being appraised, and its highest and best use.
After inspecting the subject property and gathering property-specific data, apprais-
ers inventory the supply of properties that constitute the major competition for the
subject property in its defined market.
Competitive Supply Inventory

The supply inventory includes all competitive properties, whether the market in ques-
tion involves rental units (i.e., properties that meet the needs of space users) or properties
that have been sold or are being offered for sale (i.e., properties that meet the needs of
investors or owner-users). The subject property will also have to be able to compete in a
future market. Therefore, an appraiser’s investigation of the supply inventory often must
cover not only existing competition but also prospective projects that will compete with
the subject property.
Measures of Demand
Along with the supply inventory of major competitive properties, appraisers analyze
the prospective demand for the subject property. An appraiser cannot assume the
current use is necessarily the use for which the most demand will exist in the future.
Even in the most stable markets, subtle shifts in the market appeal or utility of a
category of properties can put some properties at a competitive disadvantage and
benefit others. Even in volatile markets characterized by rapid changes due to factors
such as accelerating growth, precipitous decline, or an upturn in proposed construc-
tion, appraisers need to quantify demand in some manner.
The specific techniques applied to study market demand can be highly sophis-
ticated and may fall outside the scope of normal appraisal practice. In some cases
an appraiser might use data compiled by special market research firms (proprietary
data) to supplement the appraisal. All appraisers should, however, develop an under-
standing of market research techniques and acquire the skills needed to conduct basic
demand studies. (For further discussion of market research and analysis techniques,
Data Collection 95
see Chapters 15 and 16.) Of course, the data included in an appraisal report should be
directly relevant to the property being appraised and the market in which the property
competes. Appraisers should take care to include relevant data in the report and leave
out irrelevant information. For example, a client would be understandably annoyed
with a report prepared to value an apartment property that includes a detailed market
analysis of retail and office properties but only a cursory analysis of the market for
apartment properties. Similarly, a single-tenant, owner-occupied property should not
be valued using multitenant comparable properties. Great care should be exercised
when importing data into a report from the workfile of a previous assignment to make
sure that the imported information is relevant to the current assignment.
Data Sources and Verification

While many sources for macro- and micro-level data remain largely unchanged, the man-
ner in which appraisers go about gathering and organizing data has been transformed by
the digital age. The time and effort appraisers once spent locating property and trans-
action data and managing that data in various formats is now more often devoted to
ordering data and eliminating unnecessary or irrelevant data from the readily accessible
pools. In many ways, the current availability of certain data poses a greater challenge
and requires sharper skills than the skills required to find
similar data prior to the internet. Finding relevant data
The terms of use stipulated in small data sets is considerably easier than eliminating
by data sources may vary, so irrelevant data from seemingly endless data sets.
appraisers should be aware
of any limitations a specific Computing power has also been growing at expo-
vendor may place on the use nential rates. Software solutions and computers power-
of data. Likewise, appraisers ful enough to run them were previously only available
who purchase data should to major companies with big budgets, but now they
be aware of any disclaimers are affordable and ubiquitous. Organizing, summariz-
related to the accuracy of
the data and responsibility ing, and describing large quantities of data is required
for errors resulting from the to remain competitive in the current marketplace, and
use of the data. fortunately the tools needed are available, affordable,
and relatively easy to use.
Sources of Macro-Level Data

The macro-level data needed to appraise real property is available from a wide vari-
ety of sources. A substantial amount of information is compiled and disseminated by
federal, state, and local agencies. Trade associations and private business enterprises
may also provide data. Table 9.3 lists some common sources of macro-level data.
Macro-level data is an integral part of an appraiser’s office files. Data obtained
from various sources can be cataloged and cross-indexed. Macro-level data such as
multiple listing information and census data can be accessed by computer. Many
local and regional planning and development agencies computerize the following
information by geographic area:
• Housing inventory and vacancies
• Demolitions and conversions
• Commercial construction
• Household incomes

Table 9.3 Commonly Used Sources of Macro-Level Data
Council of Economic Advisors
Publication The Economic Report of the President
Information Available Information on
• The labor force, employment, and industrial production
• Tax policy
• Technology
• Government regulation
• Income
Where To Find It www.whitehouse.gov/wp-content/uploads/2019/03/ERP-2019.pdf
Federal Reserve Board
Publication Federal Reserve Bulletin
• Gross national product
• Gross domestic product
• National income
• Mortgage markets
• Interest rates
• Installment credit
• Sources of funds
• Business activity
• The labor force, employment, and industrial production
• Housing and construction
• International finance
Where To Find It www.federalreserve.gov/publications.htm
Federal Housing Finance Agency
Information Available Information on residential market conditions
Where To Find It www.fhfa.gov
National Vital Statistics System
Publications National Vital Statistics Reports
Information Available Statistics on birth and death rates
Where To Find It www.cdc.gov/nchs/nvss/index.htm
US Department of Commerce, Census Bureau
Publications American Community Survey Data Briefs
American Community Survey Reports
Census of Agriculture
Census of Population and Housing
Consumer Income
Household Economic Studies
Population Characteristics
Population Estimates and Projections
Information Available • Current population
• Population estimates
• Population projections
• Consumer income
• Housing completions
• Housing permits
• Other housing statistics
• Operational and performance data for American businesses
Where To Find It www.census.gov/library/publications/time-series.html
US Department of Commerce, Bureau of Economic Analysis
Publication Survey of Current Business
Information Available • Consumer Price Index
• Wholesale price index
• Data on mortgage debt
• Value of new construction
Where To Find It https://apps.bea.gov/scb/index.htm
US Department of Housing and Urban Development
Information Available • Reports on FHA building starts, financing, and housing programs administered by the department
• FHA vacancy surveys for selected metropolitan areas
Where To Find It www.hud.gov
Data Collection 97
Table 9.3 Commonly Used Sources of Macro-Level Data (continued)
US Department of Labor, Bureau of Labor Statistics
Publication Monthly Labor Review
Information Available • Consumer Price Index
• Wholesale prices
• Monthly and annual employment and earnings figures
Where To Find It http://stats.bls.gov/opub/mlr/mlrhome.htm
State and local departments of development, local and regional planning agencies, the state demographer, and regional
or metropolitan transportation authorities
Publications Often these agencies publish directories of manufacturers that list, by county, the names of firms,
their products, and their employment figures as well as other reports.
• Population
• Households
• Employment
• Master plans
• Present and future utility
• Transportation systems
Where To Find It Use online search engines to search for relevant terms such as “economic development,” formal
names of various local agencies, or national associations of applicable agencies such as the
National Association of Regional Councils (www.narc.org) and the Association of Metropolitan
Planning Organizations (www.ampo.org).
State bureaus of employment service or state bureaus of labor
Publications Research reports on various topics, such as Workforce Analysis by Jobs (published by Ohio Labor
Market Information) and PA Quarterly Workstats (published by the Pennsylvania Center for Workforce
Information and Analysis)
Information Available County data on
• Employment
• Unemployment
• Wage rates
Where To Find It Use online search engines to search for relevant terms such as “economic development” or formal
names of state bureau of employment or labor.
Chambers of commerce
Publications Publications related to local business and demographics, e.g., the Monthly Economic Indicators
reports (published by the Austin Chamber of Commerce)
Information Available Information, often obtained from secondary sources such as the census, on
• Local population
• Households
• Employment
• Industry
Where To Find It Use online search engines to search for relevant terms such as “population statistics” or formal
names of local chamber.
Real estate associations such as the American Real Estate Society (ARES), the American Society of Appraisers (ASA),
the American Society of Farm Managers and Rural Appraisers (ASFMRA), the Appraisal Institute, Building Owners and
Managers Association (BOMA) International, The Counselors of Real Estate (CRE), the International Association of
Assessing Officers (IAAO), the Mortgage Bankers Association (MBA), the National Association of Realtors (NAR) and
its affiliates, and the Urban Land Institute (ULI)
Publications Many publications with data useful to appraisers
• Journal of Real Estate Research
• Valuation
• BOMA Industrial Experience Exchange Report
• BOMA Office Experience Exchange Report
• Real Estate Issues
• Assessing Info
• Urban Land Magazine
• Realtor Magazine

Table 9.3 Commonly Used Sources of Macro-Level Data (continued)
• National and regional economic indicators
• Existing home sales for the nation as a whole and for individual regions
• Office vacancy rates
Where To Find It www.aresnet.org
www.appraisers.org
www.asfmra.org
www.appraisalinstitute.org
www.boma.org
www.cre.org
www.iaao.org
www.mba.org
www.nar.realtor
www.houselogic.com
www.uli.org
National Association of Home Builders
Publications Best in American Living
Eye on Housing
Eye on the Economy
Information Available Information, by county and for selected cities, on
• New housing starts
• Prices
• Construction costs
• Financing
• Households
• Income distribution
• Retail sales
Where To Find It www.nahb.org
Private sources such as banks, utility companies, university research centers, private advisory firms, multiple listing
services, and cost data services
Publications White papers and research reports
• Bank debt
• Department store sales
• Employment indicators
• Land prices
• Corporate business indicators
• Mortgage money costs
• Wage rates
• Deeds
• Mortgage recordings
• The installation of utility meters
Where To Find It Utilities
• www.utilityconnection.com
University research centers
• https://robinson.gsu.edu/research/
• www.lincolninst.edu/research-data/data-toolkits
• https://wsb.wisc.edu/faculty-research/academic-departments/real-estate/featured publications
• New land use by zoning classification

• Population and demographics
• Housing forecasts
In recent years, many databases have been developed for online access to in-
formation. Such databases cover a broad range of topics and offer many options to
Data Collection 99
appraisers performing general or specialized research. The information available is
virtually unlimited and includes topics such as
• Current and historical news
• Industry analyses and reports
• Corporate earnings and analyses
• Local, regional, and national Yellow Pages listings
• Publication indexes and articles
Developments in computer software and hardware have resulted in low-cost,
high-performance database combinations for appraisers. Some databases are con-
tained in a single computer, while others are shared by several computers through lo-
cal networks or are stored in and accessed through cloud storage services (i.e., virtual
data storage space usually through a third party). Ongoing improvements in tele-
communication programs and facilities, word processing, and electronic spreadsheets
have facilitated appraisal analysis and report writing, as has convenient, stable, and
secure access to database information.
Sources of Micro-Level Data

Like sources of macro-level data, sources of micro-level data are diverse. Real prop-
erty appraisal assignments almost invariably begin with a web search (e.g., using
Google, Bing, Yahoo, or another search engine) for the subject property by address,
tax parcel number, or building name, if applicable. The advent of single-property
websites for residential and commercial real estate marketing and building websites
directed at tenants and the communities served by the building’s tenants can by
themselves provide a tremendous amount of micro-level data. These sites are useful
places to launch a larger search for micro-level data.
In addition to the data obtained from public records and published sources,
personal contact with developers, builders, brokers, financial and legal specialists,
property managers, local planners, and other real estate professionals can provide
useful information. Practicing appraisers need communication skills as well as ana-
lytical techniques to research sales, improvement costs, and income and expense data
thoroughly in performing appraisal assignments. Table 9.4 lists some commonly used
sources of micro-level data.
Public Records
Appraisers search public records for a copy of the property deed to the subject or
comparable properties as needed. In most jurisdictions, public property records can
now be searched electronically. The deed provides important information about the
property and the sales transaction, including the full names of the parties involved,
the transaction date, and a legal description of the property. The property rights in-
cluded in the transaction and any outstanding liens on the title may also be indicated
in some areas. Note that an appraiser who develops an opinion of market value must
report and analyze all sales of the subject property that occurred in the three years
prior to the date of value.5 Any agreements of sale (contracts), options, or listings that
5. The emphasis in Standard 1 of the Uniform Standards of Professional Appraisal Practice is to “correctly complete research and analyses neces-
sary to produce a credible appraisal.” The requirement in that standard to research and analyze sales within the three years prior to the effective
date of the appraisal is a minimum period. In some situations, researching, analyzing, and reporting a longer history will be necessary to produce
credible assignment results.

Table 9.4 Sources of Micro-Level Data
CBRE Corporate real estate services site with listing information as
www.cbre.us well as local market research reports
Colliers International Corporate real estate services site with listing information as
www2.colliers.com/en well as local market research reports
CoStar Database of researched information including properties for
www.costar.com sale, properties for lease, verified comparable sales transactions,
and tenant information. Subscription basis.
Cushman & Wakefield Corporate real estate services site with listing information as
www.cushmanwakefield.com well as local market research reports
Jones Lang LaSalle (JLL) Corporate real estate services site with listing information as
www.us.jll.com/en well as local market research reports
LoopNet Site with listing and sales information. Some free; some
www.loopnet.com subscription based.
Marcus & Millichap Real Estate Investment Services Corporate real estate services site with listing information as
www.marcusmillichap.com well as local market research reports
NAI Global Corporate real estate services site with listing information as
www.naiglobal.com well as local market research reports
RealtyRates.com Commercial real estate investment, financial and market rates
www.realtyrates.com and returns for properties across the United States. Some free
survey data and some by subscription only.
Reis, Inc. (Real Estate Solutions by Moody’s Analytics) Commercial real estate performance information and analysis
www.reis.com at the metro (city), submarket (neighborhood), and property
level. Includes some sales data, rental data, new construction
data, real estate market information, and other data. Subscriptions
for a fee. Appraisal Institute members get a discount.
Site to Do Business Demographic data with robust reporting and analytical tools.
www.stdb.com The company has different subscription levels with one free
for Appraisal Institute members and a more complete use of
the site for a fee.
Transwestern Corporate real estate services site with listing information as
www.transwestern.net well as local market research reports
are current as of the date of appraisal also must be analyzed. Of course, listing the
sales or other agreements is just a start. Analyzing this data will be explored in depth
in the discussion of the sales comparison approach in subsequent chapters.
Occasionally the names of the parties may raise a concern that unusual motiva-
tions were involved in the sale. For example, a sale from John Smith to Mary Smith
Jones may be a transfer from a father to a daughter. A sale from John Smith, William
Jones, and Harold Long to the SJL Corporation may be a change of ownership in name
only, not an arm’s-length transaction arrived at by unrelated parties under no duress.
In some states the law requires that the consideration paid upon transfer of title
be shown on the deed. However, this consideration does not always reflect the actual
sale price. Although some states require that the actual consideration be listed on the
deed, other states—i.e., nondisclosure states—allow the consideration to be reported
as “$10 and other valuable consideration.”
The local tax assessor’s records may include property data for the subject proper-
ty and comparable properties, with land and building sketches, area measurements,
sale prices, and other information. In some locations, legal or private publishing
Data Collection 101

services issue information about revenue stamps and
listing other facts pertaining to current property transfers.
A written contract in which an
owner employs a broker to Listings and Offerings
sell his or her real property.
Whenever possible, an appraiser should gather infor-
offer
mation about properties offered for sale. An appraiser
A set of terms presented
by the bidder or prospec-
can request to be added to the mailing lists of banks,
tive buyer or tenant that are brokers, and others who offer properties for sale. Ad-
subject to negotiation. If the vertisements of listed properties suggest the strength
other party, a seller or land- or weakness of the local market for a particular type
lord, accepts these terms, the of property and the sales activity in a particular area.
offer will result in a contract.
Information on purchase offers may also be obtained
from brokers or managers. Listings usually reflect the
upper limit of value, while offers commonly set the
lower limit of value.
Listings and offerings can be useful indicators of the values anticipated by sell-
ers and buyers and reflect the likely turnover of competitive properties. Listings are
usually set at a level that will excite market interest and therefore may be employed
to test market activity. They are relevant market phenomena that appraisers consider
in analyzing competitive supply and demand. An appraiser may find that tabulating
information about competitive properties in a market data grid facilitates comparing
the market position of the subject property to that of the competition.
Every major market in the United States is served by a multiple listing service
(MLS). In this digital age, all MLS data is published electronically. An MLS primarily
contains data on residential properties listed for sale during the calendar year or fiscal
quarter and cites their listing prices. The service will contain fairly complete informa-
tion about these properties, including descriptions and brokers’ names. However, details
about a property’s square footage, basement area, or exact age may be inaccurate or
excluded. In certain areas, access to the multiple listing service or electronic databases
can be purchased. Multiple listing services sometimes publish the sale prices of proper-
ties that have been sold. In the past, only a small percentage of commercial, industrial,
or special-purpose properties were included in traditional MLS databases, but more
recently commercial MLS systems have proliferated through the efforts of commercial
boards of Realtors.
There have been some limited mergers of MLS organizations that overlap or
share members, but the impetus for large-scale mergers in this area has been limited
by competitive concerns and potential issues cited by the US Department of Justice.
Large national brokerage companies such as Realogy and Re/Max have aggregated
a variety of disparate data on a national level and made this information available
to consumers. In 2008, the National Association of Realtors established the Real-
tors Property Resource, a national database of property information available only
to members of the organization. Unfortunately, competition among aggregators to
amass the largest number of listings may lead to poor quality data, i.e., institutional
emphasis on quantity over quality control increases the likelihood of duplicates,
dated information, and incorrect information in the databases.
The potential for misuse of pooled data is a concern. Ensuring the confidentiality
of certain information in real property transactions is a continuously evolving issue.
Both the Uniform Standards of Professional Appraisal Practice and federal legislation

such as the Gramm-Leach-Bliley Act of 1999 set forth privacy requirements regard-
ing confidential information. Certain shared databases allow for restricted access to
certain fields within data records deemed confidential by the contributor of the data;
other databases only pool data that is not considered confidential.
Currently, the dominant trend in this area is the increased exposure of data to
the public. Zillow, Trulia, Redfin, and Realtor.com (among others) are increasingly
making data that was formerly guarded by companies such as Re/Max and Realogy
available to consumers. This empowerment of consumers is expected to continue to
drive a move toward less restricted data access.
Advances in artificial intelligence (AI), blockchain databases, and automated
valuation models (AVMs) have the potential to transform real estate appraisal. Block-
chain databases allow for data sharing in a decentralized “peer-to-peer” network.
Advances in AI and AVMs will increase the amount of available data, the speed at
which the data can be accessed, and the ways that the data can be sorted and nar-
rowed down by specifications. General technological advances will also make access-
ing this data easier on more compact and lightweight devices. In general, appraisers
can look ahead to more data being more widely available.
Published News
Most city newspapers feature real estate news, and many business trade publications
cover real estate activity on a local, regional, or national basis. Although some of the
news may be incomplete or inaccurate, an appraiser can use this secondary source to
confirm details because the names of the negotiating brokers and the parties to trans-
actions are usually published.
Market Participants
Other real estate professionals such as brokers, appraisers, managers, and bankers
can often provide information about transactions and suggest valuable leads. Indi-
vidual sources may be definitive, but if the information obtained from real estate
professionals is third-party data, an appraiser should look for separate verification.
Personal verification, particularly relating to confirmation of comparable rentals and
sales, is an essential part of the appraisal process.
The Real Estate Transaction Standard (RETS) and RESO Web API
The Real Estate Transactions Standard (RETS) was created in 1999 as a collaborative effort between real es-
tate brokers, franchises, associations, and technology vendors with the goals of simplifying the transfer of real
estate information from system to system and providing brokers with efficient control over their listing data. The
adoption of this standard across the industry allowed brokers to enter listings once and deliver them when and
where as needed, including to national property databases. However, as more real estate activity moved online,
duplication of property listing databases across the web resulted.
In 2018, the Real Estate Standards Organization (RESO) announced its plan to retire the Real Estate Transac-
tions Standard and replace it with RESO Web API. RESO Web API is expected to provide a more simplified and
streamlined process, more coordination with the industry, and more accelerated technological developments.
The goal of this standard is to provide a more open data approach using the representation state transfer
technology that is widely used by many industries and to encourage and promote access to real estate data
directly from a variety of web-based and mobile applications. Multiple listing services, brokers, and technology
partners are required to transition to the new platform.
Data Collection 103

Sources of Competitive Supply and Demand Data
A competitive supply inventory is compiled in several steps:
1. An appraiser first conducts a field inspection to inventory competitive properties
in the subject market area and competitive market areas.
2. The appraiser then can interview owners, managers, and brokers of competitive
properties in the area as well as developers and city planners. Field inspection
and interviews are especially important because investors rely heavily on local
competitive supply and demand analyses.
3. An examination of building permits (both issued and acted upon), plat maps,
and surveys of competitive sites provides insight into prospective supply.
4. Data on available space, as well as vacancy, absorption, and turnover rates in
specific property markets, can be obtained from electronic databases and reports
prepared by real estate research firms.
Demand can be estimated using demographic data (population and vital statis-
tics) and economic data (employment and income statistics) for the market area. The
Bureau of the Census (Department of Commerce) and Bureau of Labor Statistics com-
pile and publish statistical data, which is often also available in electronic form. Other
private and public sources provide historical data and projections based on small area
populations. Appraisers who rely on projections prepared by market research firms
should have a clear understanding of the methodology used to make the projection.
Otherwise the data may represent little more than a blind data set. To test the reason-
ableness of small area projections, comparisons should be made between the demo-
Geographic Information Systems and TIGER Data

The Topographically Integrated Geographic Encoding and Referencing (TIGER) system created by the US
Bureau of the Census in the 1980s is of special relevance to appraisals of sites being considered for devel-
opment. TIGER files contain the geographic base information used to create maps based on the most recent
census and are essential ingredients in a geographic information system (GIS). A geographic information
system using TIGER/Line data allows an appraiser to analyze information on traffic analysis zones, acreage
available for development, zone densities, and other physical characteristics and geographical relationships
in a market area. Other GIS databases contain information about local taxes (e.g., property assessments,
school levies) and infrastructure (e.g., gas lines).*
Geographic information system technology facilitates the addition of geographic reference data to indi-
vidual items in real estate databases. Personal computers and larger, networked computer workstations can
draw on this information to map or model the spatial referents and show the spatial relationships among the
data points. Equally important, spreadsheets or tabular grids can be produced in written formats, which can
help the user better understand these relationships.†
Data from public sources at local, state, and national levels is available and, in most cases, less expensive
than the cost of undertaking primary research. A combination of public data and other data available from
proprietary sources allows an appraiser to assemble and map information and then analyze that information
in ways previously regarded as technically infeasible or too costly. Initially, real estate professionals were most
interested in the mapping capabilities of GIS, but new technology is helping expand opportunities for data
analysis and promoting greater understanding of the results of that analysis.
* See also Gilbert H. Castle III, editor, GIS in Real Estate: Integrating, Analyzing, and Presenting Locational Information (Chicago: Appraisal
Institute, 1998).
† See also Mark R. Linné and Michelle M. Thompson, editors, Visual Valuation: Implementing Valuation Modeling and Geographic Information
Solutions (Chicago: Appraisal Institute, 2010).

GIS can integrate digital maps with point-specific or area-specific data to answer basic questions such as
• What is found in a specific location?
• Where within a given area is a specific feature, activity, or event located?
• What changes have occurred in an area over a given period of time?
• What spatial patterns characterize a given area?
• What impact will a specific change have on the area?
The data used to generate these maps is typically found in computer databases that include referents to a
specific point on the earth’s surface (i.e., latitude and longitude) or a specific area (e.g., city, zip code area,
census tract).
GIS as a Valuation Tool
A geographic information system (GIS) is a tool that allows users to analyze, interpret, and display data that
is associated with a specific location on the earth. It begins with a blank model of earth that provides a
space to store, display, and compare two or more types of data on the same plane. It can be used to under-
stand how data is distributed, to display geospatial data, and to identify data based on spatial characteris-
tics, among other capabilities. These tools are becoming increasingly important to appraisers as they engage
in mass appraisal assignments.
GIS data represents features of the real world in two ways—as a vector or as a raster. Vectors are files of
data that exist in discrete dimensions, whereas rasters are files that contain continuous data, existing in all
areas that the data represents. Rasters usually look like an image because the data does not stop as vectors
do. Each pixel in a raster contains a value that is itself a data point. An example of a raster is a digital eleva-
tion model (DEM). DEMs often look like a grayscale aerial image because each pixel in the file has a value
that is represented by the median elevation of the location represented by the raster.
Vectors can be in the form of points, lines, or polygons. Points are associated with one specific latitude
and longitude and have no dimension. Lines are one dimensional data, and polygons are data of two dimen-
sions. An example of a feature represented by a point is the source of a leak. Examples of lines are roads or
rivers, and examples of polygons are land parcels or lakes. Additionally, nonspatial data in the form of a table
can be joined to spatial data to add information to the features represented in the GIS project.
A GIS allows its user to spatially compare data from different sources. Data is sourced from various reli-
able agencies. For example, sales data could be obtained from a multiple listing service (MLS), parcel data
in the form of polygon vectors from the county tax assessor, contaminated zones from an environmental
scientist, and population data from the US Census Bureau. When a table of sales data is joined to parcel
vectors, the researcher is able to identify the locations of all sales in the study and compare their spatial
relationship to the source of the detrimental condition.
GIS software allows the user to analyze spatial relationships, determine distances between two types of
data, display these relationships as they relate to each other, and communicate data in a way that is easy to
understand visually. Additionally, GIS software is used to verify that the data used is where it is expected to be.
Given sufficient information, the system can quickly pinpoint properties with specific characteristics. For
example, the system can identify the locations of all parcels of vacant land in a given county that have the
following characteristics:
• Contain 40 or more acres
• Meet specific soil suitability standards
• Are equipped with municipal water and sewer lines
• Are zoned for residential use
• Have an elementary school within a one-half mile radius and are adjacent to residential neighborhoods
where the median home value exceeds $250,000
The dramatic increase in the use of GIS equipment is the result of three factors:
• The decline in the price of high-powered personal computers
• Improvements in GIS software
• Expansion of commercially available geocoded data
Data Collection 105

In addition to commercially available TIGER data, accurate digital base maps for most areas of the United
States are available at reasonable prices from the United States Geological Survey (USGS). (See Chapter 12
for more discussion of topography and land or site analysis.) Many local governments sell geocoded digital
data on individual parcels that is compiled from assessment data and public record information. In the
future, data vendors will continue to expand the amount of commercially available data compatible with GIS.

graphic data and the supply data collected in the specified market. Supply data may
include building permits and market sales or absorption rates kept by public agencies
such as building inspection, city planning, and public works departments.
Personal observation is also useful in estimating local demand. For example, the
planned closing of an army base should be considered in analyzing the future demand
for adjacent commercial properties such as dry cleaners, motels, bars, and restaurants.
An appraiser who has observed development near highway interchanges will be able
to anticipate that a proposed freeway interchange will generate future demand for
shops, service stations, and motels catering to the needs of motorists and tourists.
Selecting Comparable Data and Establishing Comparability

Descriptions and classifications of the characteristics and components of comparable
properties are assembled in land and improvement analyses. An appraiser selects
data from these analyses and analyzes it in the sales comparison, cost, and income
capitalization approaches. The data used for comparison in the three approaches
should come from properties that are similar to the property being appraised. A
good comparable sale is a competitive alternative—i.e., a property that the buyer of
the subject property would also consider. The selection of comparables is directed
to some extent by the availability of data. Investigation of an active market usually
reveals an adequate and representative number of transactions within a restricted
area and time period.
An appraiser gathers broad information about a market from its pattern of sales.
Important market characteristics can be revealed by significant factors such as
• Number of sales
• Period of time covered by the sales
• Availability of property for sale
• Rate of absorption
• Rate of turnover—i.e., volume of sales and level of activity
• Characteristics and motivations of buyers and sellers
• Terms and conditions of sale
• Use of property before and after its sale
While analyzing data to establish comparability and select sales, an appraiser begins
to form certain conclusions about the general market, the subject property, and the
possible relationships between the data and the subject property. The appraiser iden-
tifies the following:
• Market strengths and weaknesses
• The probable supply of, demand for, and marketability of properties similar to
the property being appraised
• The variations and characteristics likely to have the greatest impact on the value
of properties in the market
Thus, an appraiser analyzes data against a background of information about the par-
ticular area and the specific type of property.
The information needed to apply the cost and income capitalization approaches
must often be obtained from market sources other than sales. This information may
Data Collection 107

also be used to refine adjustments made in the sales comparison approach. In the
investigation of general and market area data, an appraiser learns about trends in
• Lease terms
• Operating expenses
• Vacancy rates
Examining trends in the market where the subject property is located provides ad-
ditional specific data that can be used to derive value indications and successfully
complete valuation assignments.
The geographic area from which comparable sales can be selected depends on
the property type. In valuing certain types of retail property, only properties with
main street frontage may be pertinent. For many large industrial properties and most
investment properties, the entire community should be studied. For larger properties,
regional or national markets may be relevant. For residential appraisals, adequate
data can sometimes be found within a block of the subject property. Even in these
cases, however, an appraiser should consider the broader market to place the subject
property and the comparables in a general market context.
When comparable sales data is scarce in the subject property’s immediate area,
appraisers may need to extend the data search to adjacent market areas and similar
communities. An appraiser must establish the comparability of the alternative market
before using data from that market. When the selection of data is limited to an unac-
ceptably narrow sample of current market activity, an appraiser may decide to use
sales that are less current or to interview brokers, buyers, sellers, owners, and tenants
of similar properties in the area to obtain evidence of potential market activity such
as listing prices or offers to purchase.
With computer analysis, a large number of properties can be studied in the
course of a single assignment, which may generate a deeper understanding of each
property’s contribution to, and influence on, a given market. Appraisers should pay
attention to several factors to judge if data is useful:
1. The degree of comparability
2. The quantity of information available
3. The authenticity and reliability of the data
Appraisers must not assume that all data pertinent to an assignment is completely re-
liable. Sales figures, costs, and other information subject to misrepresentation should
be scrutinized for authenticity.
Appraisers seek data that will facilitate accurate comparisons, but every real estate
parcel is unique. The comparability of properties varies, and an appraiser may find it
necessary to place less confidence on a given comparable. Nevertheless, an appraiser
may want to consider this comparable for its evidence of, and effect on, the marketplace.
Appraisers have a special responsibility to scrutinize the comparability of all data
used in a valuation assignment. They must fully understand the concept of compara-
bility and should avoid comparing properties with different highest and best uses, lim-
iting their search for comparables, or selecting inappropriate factors for comparison.

Verification
A primary purpose of verifying a sale of real property is to make sure that the sale
occurred under conditions that meet the definition of value used in the appraisal.
The verification process also provides an appraiser with an opportunity to obtain
accurate information about the property and to better understand the attitudes and
motivations of the buyer and seller. An appraiser asks a few essential questions when
verifying data:
• Is the data correct?
• Is the data complete?
• Was the sale or rental an arm’s-length transaction?
• Were there any contingencies?
• Were any concessions involved?
• Does the data conform to relevant standards or regulatory requirements?
• Did any special or unusual conditions affect the sale or rental?
The Uniform Standards of Professional Appraisal Practice require that apprais-
ers “collect, verify, and analyze all information necessary for credible assignment
results.”6 Appraisers investigate how much verification of data will be necessary for
a specific assignment in the determination of scope of work. Many users of appraisal
services permit the use of secondary data that has not been directly verified, whereas
others require confirmation with more than one party to the transaction and stipulate
who must perform the verification task. For example, an appraisal of a single-unit
home for mortgage lending purposes is likely to require more verification of specific
property data than a mass appraisal assignment involving the statistical analysis of a
large database of property information purchased from a data vendor. Likewise, the
Uniform Appraisal Standards for Federal Land Acquisitions require an appraiser to
talk directly to a party to the transaction to verify data used in an appraisal assign-
ment subject to the UASFLA standards, which is a higher level of verification than is
usually necessary in the aforementioned appraisal for mortgage lending purposes.
In addition to the scope of work of the assignment, the reliability of the origi-
nal data source also has an effect on the scope of data verification. By its nature, the
primary data an appraiser collected himself or herself has already been verified,
whereas secondary data such as comparable sales and rental data purchased from
a vendor is unverified. Market data from informal sources (newspapers, real estate
trade magazines, websites) is likely to be less reliable than data from a vendor and
therefore may need to be verified before being used in an appraisal.
The most common verification technique is interviewing market participants. Ef-
fective interviewing techniques are a matter of personal style.
Data Organization
Data can be aggregated and analyzed in numerous ways. Market data tables are the
most common tool used to organize data. They can be as detailed as required for
meaningful analysis. In a basic table, an appraiser lists significant characteristics of
the subject and comparable properties that have been isolated. This type of table sum-
6. Standards Rule 1-4 of Uniform Standards of Professional Appraisal Practice, 2020-2021 ed. (Washington, DC: The Appraisal Foundation, 2020), 18.
Data Collection 109

marizes the data presented and allows the appraiser to
primary data identify those factors that may account for differences
Information that is gathered inin value and those that probably do not. The data array
its original form by the analyst.
table only presents data. It allows the reader to view the
secondary data
relevant data in a format that facilitates easy compari-
Information that is not
gathered in its original form sons of relevant features. It is not an adjustment grid
by the analyst. but can be used for comparing the properties quali-
tatively. In an adjustment grid, the sale properties are
compared to the subject and specific adjustments are
made to their prices.
A market data table should include the total sale price of each comparable
property and the date of each sale, which can be expressed in relation to the subject
property’s date of valuation (e.g., one month ago or 16 months ago). The table also
includes information about the property rights conveyed, the financial arrangements
of the sale, and any unusual motivations of the buyer or seller that may have resulted
in a negotiating advantage, such as a desire to liquidate a property for inheritance tax
or to acquire a particular property for expansion.
The market data table can include characteristics of the subject and comparable
properties, information on sales transactions, and pertinent market data from other
sources. An appraiser may choose to use two or more market data tables, i.e., one
table for comparable sales data and other tables for information derived from other
sources. Isolating micro-level data may indicate the type of information an appraiser
will be able to derive from the collected data and identify variations among proper-
ties that may be significant to their value.
In examining the market data table, an appraiser may find that certain data is not
pertinent and will not be useful in applying the approaches to value. For example, if
an appraiser who is valuing an industrial property finds that the subject and the com-
parables all occupy one-acre sites, site size will probably not account for differences
in the sale or unit prices of the properties. If the percentages of office space in the
properties vary, however, the difference may have an effect on value.
Analysis of the data array table may indicate that additional data is required
and that the appraiser needs to create other tables to include more information or to
isolate the data required for specific approaches. Appraisers should see data analysis
as a process and the market data table as a tool that facilitates this process and the
derivation of valid indications of property value. Although many market data tables
may be prepared in the development of an appraisal, not all tables are necessary for
the appraisal report. Only those that will help to explain the significance of the data
to the client need to be included in the appraisal report. (Further discussion and ex-
amples of the use of adjustment grids for data analysis are provided in Chapter 21.)

Economic Trends in Real Estate 10
Markets and Capital Markets
Value is affected by the interplay of social, governmental, physical, and economic forces,
which are continually changing, often in a cyclical pattern. Although the value of real
estate may seem relatively stable in comparison to the value of stocks or commodities, it
is still subject to the multitude of pressures and influences created by this interplay.
Appraisers collect data that illustrates the direction of the changes in markets
as well as their probable extent and influence to identify and to reasonably project
trends. A trend may be defined as a series of related changes brought about by a
chain of causes and effects. For example, an economic trend being projected in an
appraisal analysis may be rooted in social or governmental causes and effects like
demographic shifts in an area or changes in federal tax laws. The direction, speed,
duration, strength, and limits of these economic trends are forecast through economic
base analysis, statistical analysis, market analysis, and analysis of economic indica-
tors and surveys. Table 10.1 shows some of the specific market characteristics and
other general data that appraisers investigate to gain insight into economic trends.
The social forces studied by appraisers primarily relate to population character-
istics. The demographic composition of the population reveals the potential demand
for real estate, which makes the proper analysis and interpretation of demographic
trends important to an appraiser’s analysis.
Political and legal activities at all levels of government can have a great effect on
property values. Federal, state, and local governments provide many facilities and
services that affect land use patterns. In fact, public sector activities at a particular
time or in a particular place may overshadow the natural market forces of supply
and demand. For example, changes to federal banking regulations have a tendency
to reverberate throughout the capital markets, alternately loosening and tightening
the supply of funds available for investment in real estate. More direct governmental
action like the decision to bail out major car manufacturers in 2008-2009 can have a
major effect on the economies of cities and states with an economic base dominated
by the automobile industry, like Detroit and the surrounding areas in Michigan.
Although many real estate professionals associate the word environmental pre-
dominantly with the conservation of natural resources (e.g., wildlife, timberlands,
wetlands) and the regulation of man-made pollution, appraisers understand the
environmental forces that affect the value of a specific real property in relation to the
property’s location. (Note that the treatment of hazardous substances in real estate
appraisal is discussed in Chapter 12.) Location analysis considers the time-distance
relationships, or linkages, between a property or neighborhood and all probable
origins and destinations of residents coming to or going from the property or neigh-
borhood. Location has both an environmental and an economic character. Time and
distance are measures of relative access, which may be considered in terms of site
ingress and egress, the characteristics of the areas through which traffic to and from
the site passes, and transportation costs to and from the site.
To determine the influence of economic forces on value, appraisers analyze the
relationships between current and anticipated supply and demand and the economic
ability of the population to satisfy its wants, needs, and demands through its pur-
chasing power. Economic trends and considerations may be studied in greater detail
as an appraiser’s analysis focuses on successively smaller geographic areas, as shown
in the later chapters in this section of the text.
The economic trends that affect the value of real property can be seen in the
money supply, the capital markets, and the overall real estate marketplace itself. To
keep abreast of the relative health of the marketplace in which real property trades,
appraisers continuously gather data on the changes in those markets, which are the
focus of the remainder of this chapter.
Real Estate Markets

The essential appraisal activity of real estate market analysis focuses on the motiva-
tions, attitudes, and interaction of market participants as they respond to the par-
ticular characteristics of real estate and to external influences that affect its value.
(Real estate market analysis is discussed in detail in Chapters 15 and 16.) This focus
underscores the need for objective real estate appraisal in a free market economy and
the responsibility of appraisers to the communities they serve.
Real estate markets can be analyzed from two perspectives:
1. As a market of investors buying and selling assets
2. As a “fundamental” market of space users
Both of these distinct,
but related, market seg-
Labels for Two Types of Real Estate Markets ments operate within the
A variety of paired labels are used in the professional literature to context of the overall real
describe the asset market and the fundamental market: estate market. The par-
• The property market and the space market ticipants in the asset mar-
• The transaction market and the physical market ket are the buyers and
• The capital market and the fundamental market sellers of real estate assets
For more discussion of the distinction between the asset market and that compete with other
the fundamental market, see Stephen F. Fanning, Market Analysis for investments in the larger
Real Estate, 2nd ed. (Chicago: Appraisal Institute, 2014), Chapter 10. capital market such as
stocks, mutual funds,

Table 10.1 Forces that Influence Value in Real Estate Markets and Relevant General Data
Social forces • Total population
• Population composition by age and gender
• Rate of household formation and dissolution
• Attitudes toward education, law and order, and lifestyle options
Governmental forces • National, state, and local tax laws and policies
• Public services such as fire and police protection, utilities, refuse collection, and transporta-
tion networks
• Local zoning, building codes, and health codes, especially those that obstruct or support
land use
• Special legislation that influences general property values:
- Rent control laws
- Statutory redemption laws
- Restrictions on forms of ownership such as those imposed on condominiums and
timeshare arrangements
- Homestead exemption laws
- Environmental legislation regulating new developments and wetlands as well as the
control of hazardous or toxic materials
- Legislation affecting the types of loans, loan terms, and investment powers of mortgage
lending institutions
Environmental forces • Climatic conditions
• Topography and soil
• Toxic contaminants such as asbestos, radon, and PCBs
• Natural barriers to future development such as rivers, mountains, lakes, and oceans
• Primary transportation systems, including federal and state highway systems, railroads,
airports, and navigable waterways
• The nature and desirability of the immediate area surrounding a property
Economic forces • Employment
• Wage levels
• Business expansion
• Economic base of the region and community
• Price levels
• Cost and availability of mortgage and equity capital
• Inventory of available vacant and improved properties
• Factors limiting additions to inventory
• New development under construction or in the planning stage
• Occupancy rates
• Rental and price patterns of existing properties
REITs, bonds, hedge funds, private equity, mortgages, venture debt, and mortgage-
backed securities. In contrast, the participants in the fundamental market are space
users who are concerned with the use of the physical space of real estate for a specific
purpose (e.g., as a residence, as a place to house business operations).
For example, in the asset market a multitenant office building would compete
with similar properties for potential purchasers, whose financial decision-making
process would involve comparing the projected income-producing capability of the
Economic Trends in Real Estate Markets and Capital Markets 113

property with the potential returns from other capital investments. The fundamental
market for the same property would more likely consist of potential occupants of the
property, who would base their financial decision to rent or buy space in the building
on the suitability of the property as office space (e.g., location and amenities) and the
affordability of that option to the potential user.
The financial return in the asset market is often driven by short-term resale expec-
tations rather than the sustainable, long-term income potential of the property. The
primary determinants of short‑term demand in the asset market for real estate are the
availability of cash or credit for investment and the level of interest rates. In contrast,
the market cycle of the fundamental market, sometimes called the “long-term real es-
tate cycle,” is primarily a function of changes in employment, population, and income.
The Relative Efficiency of Markets

The efficiency of a market is tied to the behavior of buyers and sellers (or lessors and
lessees) as well as the characteristics of the products traded in the market. Real estate
markets can differ significantly from the markets for other goods and services, and
real estate markets have historically been considered less efficient than many other
types of markets (see Table 10.2). Real estate products are heterogeneous, and infor-
mation about real estate is often incomplete due to the confidentiality of transactions.
Also, changes in supply lag behind changes in demand for a specific real estate prod-
uct (e.g., office/warehouse space) because of the time needed to bring a new building
to market. In a more efficient market, like a stock exchange, supply quickly reacts to
changes in demand.
Real estate markets vary in terms of efficiency. For example, the highly competitive
market for existing homes is much more efficient than the market for special-purpose
properties. Since the 1990s, the securitization of real estate and increased access to
published property and transaction information, along with other changes in the larger
economy, have made some real estate markets relatively more efficient than they once
were, although significant peaks and troughs continue to exist as illustrated by the
speculative bubble of 2007-2008. Nevertheless, efficiency in the real estate marketplace
has a direct bearing on rate of return requirements. Consequently, a purchaser who un-
derstands the inefficiencies of the real estate market can usually gain benefits in terms
of rates of return, relatively stable income, inflation protection, and other factors.
However, in more recent years, some of the benefits of real estate as an asset
class have eroded. The increased access to data and new tools for data analysis likely
contributed to the destructive competition among lenders that led to the severe
downturn in real estate markets that started in 2007. The market forces that increased
the efficiency of real estate markets and the liquidity of real estate investments also
reduced the transparency of the assets pooled in heavily traded securitized mortgage
instruments, obscuring from investors the risk involved in holding the loans that
backed those securities.
Market Cycles
In the years following World War II (1946–1966), distinct patterns emerged in real
estate and general business cycles in the United States. As businesses prospered, the
demand for capital intensified, inflation accelerated, and an oversupply of goods and
services was produced. Federal Reserve monetary policy and other economic con-

Table 10.2 Comparison of “Efficient” Markets and Real Estate Markets
Efficient Markets Real Estate Markets
Goods and services are essentially homogeneous No two parcels of real estate are physically identical.
items that are readily substituted for one another.
A large number of market participants creates a There are usually only a few buyers and sellers
competitive, free market, and none of these participants interested in a particular type of property at one time,
has a large enough share of the market to have a direct in one price range, and in one location. An individual
and measurable influence on price. buyer or seller can influence price through exertion of
control on supply or demand or both.
Supply and demand are never far out of balance. The In stable real estate markets, supply and demand
market returns to equilibrium quickly through the are considered causal factors, and price is the result of
effects of competition. their interaction. Price changes are usually preceded
by changes in market activity. Supply or demand often
shifts suddenly during periods of no activity or in-
creased activity or when properties are in transition.
Buyers and sellers are knowledgeable and fully Buyers and sellers of real estate may not be well
informed about market conditions, the behavior of informed.
other market participants, past market activity,
product quality, and product substitutability. Any
information needed on bids, offers, and sales is
readily available.
Buyers and sellers are brought together by an Buyers and sellers are not brought together formally.
organized market mechanism, such as the New York
Stock Exchange. Sellers can easily enter and exit the
market in response to demand.
Goods are readily consumed, quickly supplied, and Real estate is a durable product and, as an investment,
easily transported from place to place. it may be relatively unmarketable and illiquid.
Market efficiencies lead to low transaction costs. Market inefficiencies lead to high transaction costs,
e.g., broker’s fees and commissions, closing costs.
Market participants can act on new information Market participants are not able to act quickly on new
quickly to take advantage of opportunities to information, e.g., an increase in market demand will be
increase supply to meet demand. followed by a lag as developers attempt to increase
supply but are hampered by the long development
times for new real estate products.
trols would then be used to slow the pace of the economy and keep inflation in check.
If the economy slowed too much, a recession would ensue.
When Congress wanted to revive the US economy, the industry invariably
selected to provide economic stimulation was real estate, particularly home build-
ing. Programs were developed to provide abundant, moderately priced mortgage
money. These programs usually involved loan insurance or guarantees to induce
capital managers to participate. Because there was a substantial demand for housing,
the programs were well received and residential development expanded, increasing
employment in all economic sectors. The economy finally revived, inflation started to
accelerate, and the cycle was repeated. When loan insurance and guarantee programs
supplied inexpensive long-term capital, real estate prospered and the general econo-
my expanded.
The situation today is very different from the conditions prevailing in the last
quarter of the twentieth century. The economic downturn that began in the United
States in 2007 affected all sectors of the US and global economies, especially real es-

tate. Since the real estate bubble burst, debate has continued about what governments
can do—or should do—to ease the financial risk to both lenders and property owners.
In a market economy, the larger economic cycle (see Figure 10.1) influences
the real estate cycle. As the economy expands, competition for capital intensifies,
the costs of goods and services increase, and inflation escalates. The central bank-
ing system (e.g., the US Federal Reserve System) then seeks to combat inflation by
tightening money and credit until the economy slows down. The demand for funds
subsides, interest rates decline, and economic conditions become stable enough for
businesses to expand. When the frequency of the economic cycle accelerates and its
range increases, business and monetary conditions change drastically and rapidly.
This creates an unattractive economic environment for long-term investments such as
real property.
Capital Markets
Activity in the capital markets illustrates the interaction of buyers and sellers trad-
ing long- or intermediate-term money instruments. Traditional real estate investment
Figure 10.1 Real Estate Cycles and Economic Cycles
40% 5%
30% Nareit total expected return 6.0

3%
20%
10%
1%
Index Change
0% GDP Change
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018* -1%
-10%
-20% NCREIF total expected return 6.0

-3%
-30%
-40% -5%
GDP Nareit NCREIF
Sources: National Council of Real Estate Investment Fiduciaries (NCREIF), National Association of Real Estate
Investment Trusts (Nareit), Bureau of Economic Analysis/US Department of Commerce, ULI Real Estate Economic
Forecast.
* NCREIF, Nareit, and GDP data for 2017 and 2018 are based on forecasts for these indicators in the ULI Real
Estate Economic Forecast (October 2017).
Source: PwC and the Urban Land Institute, Emerging Trends in Real Estate 2018 (Washington, DC: PwC and the Urban Land Institute, 2017), 3.

practices involve the use of two types of capital—debt and equity—and a typical
venture is structured with a substantial mortgage amount and a smaller equity con-
tribution. The most common capital market instruments are stocks, bonds, mortgages
(including junior liens and home equity loans), and deeds of trust and contracts for
deeds. Although stocks are capital market items, they are equity investments with no
fixed maturities.
Mortgages
A mortgage is a legal instrument for pledging a described property interest as collater-
al or security for the repayment of a loan under certain terms and conditions. A mort-
gage operates in conjunction with a promissory note, which specifies the interest rate
Signs of a Changing Market

A real estate bubble may be evidenced by
• The rates of return associated with a property type and the economic characteristics of tenants or users
are not typical and tend to be very low. For example, capitalization rates may be very low or indicate nega-
tive leverage, which is often a sign of speculation.
• Prices increase at a faster rate than rents.
• Rates of return decrease below long-term trends.
• Prices rise while rents and net incomes remain stable or are declining.
• Traditional buyers are replaced by new ones. “Everyone” starts to invest in real estate.
• The number of transactions increases.
• Marketing times are shorter.
• Average days-on-market decreases.
• There are very few expired listings.
• The number of properties remaining vacant after purchase increases.
• Condominium conversions become more common.
• The number of persons employed in the real estate sector (real estate sales, mortgage lending) increases
significantly.
• Rents increase faster than the ability of tenants to pay.
• Sale prices are beyond the affordability of users.
A bust market may be evidenced by
• Sales are few, at least initially, because sellers are reluctant to sell and realize losses.
• The rate of foreclosures increases.
• Seller concessions increase, both in terms of frequency and magnitude.
• Credit markets tighten. Traditional financing becomes more difficult to obtain.
• The use of “creative” financing, generally seller financing, increases. These arrangements serve to keep
nominal prices from falling, at least in the initial stages of a bust.
• Marketing times are longer.
• Average days-on-market increases.
• The number of expired listings increases.
• The number of persons employed in the real estate sector declines.
• Job growth is declining.
• Rents are not rising at the same rate as the last few years.
• Vacancy is increasing.

and other important loan terms. Mortgage loans supply
mortgage most of the capital employed in real estate investments.
A pledge of a described The parties to a mortgage are usually free to
property interest as collateral
or security for the repayment contract in any fashion they desire, subject only to
of a loan under certain terms limitations of usury and public policy. Traditionally,
and conditions. mortgage loans have been made for terms of 20 to 30
years at fixed interest rates. Mortgages with different
payment arrangements and schedules are available—
e.g., variable-rate and balloon mortgages. Types of
mortgages categorized by their repayment characteristics are shown in Table 10.3.
A borrower may pledge a real property interest to more than one lender, thereby
creating several liens. In these cases, the time sequence or order of the liens is important:
• The first loan contract executed and recorded is the first mortgage, which has pri-
ority over all subsequent transactions.
• Second and subsequent mortgages are sometimes referred to as junior liens. Be-
cause they involve more lending risk than first mortgages, higher rates of interest
are charged for second and third mortgages, which typically have shorter terms.
• Home equity loans are another common type of junior lien. Home equity loans
generally run for terms of about five years, shorter than second or third mort-
gages and, if the payments made cover only the interest on the loan, the principal
is repaid in a lump sum at the end of the loan term.
• Home equity lines of credit are similar to home equity loans, except that the bor-
rower can access this type of loan at any time up to the loan amount without
further loan approval. In terms of priority of repayment, a home equity line of
credit is similar to a home equity loan, but some lines of credit are recourse loans
for which borrowers are personally liable.
Mortgages can also be categorized based on how they are protected against the
risk of default. The three major categories are
1. Guaranteed—e.g., Veterans Administration (VA) home mortgages
2. Insured—e.g., Federal Housing Administration (FHA) mortgages
3. Conventional
FHA mortgages are the most common type of insured mortgages, but other govern-
ment bodies and private insurance companies offer loan insurance as well. Conven-
tional mortgages are neither insured nor guaranteed.
In the event of default, a borrower may have personal liability if the mortgage
was a recourse debt, whereas the lender is only entitled to the proceeds of the foreclo-
sure sale of the property if the mortgage was a nonrecourse loan. A personal guar-
antee from a borrower generally lowers the cost of financing because the risk to the
lender is reduced.
Deeds of Trust and Contracts for Deeds

A mortgage is a contract between a borrower (the mortgagor) and a lender (the
mortgagee), but a deed of trust involves a third party. A deed of trust is defined as a
legal instrument similar to a mortgage that, when executed and delivered, conveys
or transfers property title to a trustee. In such an arrangement, a borrower conveys

Table 10.3 Repayment Characteristics of Mortgages
Type Repayment Characteristics
Interest-only mortgage Nonamortizing loan in which the lender receives interest only during the term
of the loan and recovers the principal in a lump sum at the time of maturity.
Self-amortizing mortgage A mortgage repaid in periodic, usually equal, installments that include repay-
ment of part of the principal and the interest due on the unpaid balance.
Although the payments are level, the amount of principal and interest varies
with each payment. In the most common type of direct reduction mortgage,
the interest component decreases with each payment while the principal or
amortization component increases.
Adjustable variable-rate mortgage Mortgage with an interest rate that may move up or down following a specified
schedule or in accordance with the movements of a standard or index to
which the interest rate is tied.
Wraparound mortgage A mortgage subordinate to, but inclusive of, any existing mortgage on a
property. Usually, a third-party lender refinances the property, assuming the
existing mortgage and its debt service, which are wrapped around a new, ju-
nior mortgage. A wraparound lender gives the borrower the difference between
the outstanding balance on the existing mortgage and the face amount of
the new mortgage. Wraparound mortgages became widespread in periods of
high mortgage rates and appreciating property values, but they have generally
fallen into disuse with declining mortgage rates.
Participation mortgage The lender receives a share of the income and sometimes the reversion from
a property on which the lender has made a loan. Lenders may opt for this type
of arrangement either as a hedge against inflation or as a means of increasing
their total yield on the loan.
Shared appreciation mortgage The borrower receives assistance in the form of capital when buying the real
property in return for a portion of the property’s future appreciation in value.
Convertible mortgage The lender may choose to take an equity interest in the real estate in lieu of
cash amortization payments by the borrower. In this way the mortgage inter-
ests of the lender may be converted into equity ownership at specified times
during the life of the mortgage.
Graduated-payment mortgage Designed to aid borrowers by matching mortgage payments to projected
increases in income, this type of mortgage has periodic payments that start
out low and gradually increase. Because the borrower’s payments in the early
years of the loan are not sufficient to pay the entire interest due or to amortize
the mortgage, the borrower actually borrows the difference between the pay-
ments and the current interest due.
Zero-coupon mortgage Debt secured by real estate with interest payments accruing rather than
being paid by the borrower. In some circumstances, a rate of interest may be
ascribed—e.g., for income taxation.
Reverse annuity mortgage (RAM) A negative amortization mortgage that allows owners to use some or all of the
equity they have accumulated in their property as retirement income while re-
taining ownership of the property. Typically, the loan increases as more money
is borrowed and unpaid interest on the outstanding balance accumulates up
to an agreed-upon amount, which is generally scheduled to coincide with the
sale of the property.
Mezzanine loan A form of secondary financing at a higher risk with a higher interest rate ap-
plicable to the secondary position; often supplementary financing for a real
estate development project where stock in the development company serves
as collateral rather than the property itself.

or transfers property to a trustee for the benefit of a
nonrecourse loan lender. The borrower conveys title to the trustee but
Debt agreement secured by retains the right to use and occupy the property, which
real property that provides
that the lender has no claim often streamlines the process of foreclosure, allowing
against the debtor in the a lender to foreclose without going to court if the trust
event of default, but can only deed contains a power of sale clause. In some states,
recover the property. deeds of trust are used in place of mortgage contracts.
recourse debt A contract for deed, frequently called an install-
A debt agreement secured ment sale contract or land contract, is an instrument that
by real property that gives provides for the future delivery of a property deed to a
the lender legal rights
against the debtor beyond buyer after certain conditions are met. A seller finances
the right to property value; the sale of a property by permitting the buyer to pay for
equivalent to a general it over a period of time, but the title is delivered only
obligation of the debtor. after all payments are made. In the event of default,
deed of trust the buyer normally forfeits all payments made and the
A legal instrument similar seller may also elect to hold the buyer to the contract.
to a mortgage document,
except that three parties are
involved in securing the debt: Monetary Policy
the borrower, a lender, and a
trustee who holds property The US Federal Reserve System influences daily trading
title when the deed of trustactivity in the money market and the cost (i.e., interest
is executed and delivered. rates) of money market funds by regulating the money
supply as a key component of its application of mon-
The trustee transfers title to
the lender if the borrower
etary policy. The money market, in turn, greatly affects
defaults and to the borrower
if the note is repaid. the real estate industry because its short-term financing
contract for deed vehicles are needed to fund real estate construction and
A contract in which a pur- development. This is one of many ways in which the
availability and cost of money regulates the volume
chaser of real estate agrees to
and pace of activity in the real estate industry. The dis-
pay a small portion of the pur-
tinction between the money market and capital markets
chase price when the contract
is signed and additional sums,
is not sharply defined because both involve trading in
at intervals and in amounts
funds for varying terms and both are sources of capital
specified in the contract, until
the total purchase price is for all economic activities, including real estate.
paid and the seller delivers There is a difference between money and other
the deed; used primarily to commodities on the supply side of the pricing formula.
protect the seller’s interest in
The demand for money is a product of the operation
the unpaid balance because
of economic forces. The supply of money available for
default can be exercised more
lending is a function of the level of savings, which re-
quickly than it could be under
a mortgage. flects personal, corporate, and governmental accumula-
tion, both domestic and foreign.
Economics determines the amount of savings, but
the quantity of US currency is subject to regulation by
the Fed. The Fed has the power to regulate general interest rate levels, which strongly
influence the discount rates and overall capitalization rates used in real estate valu-
ation.1 Housing affordability is greatly influenced by prevailing mortgage rates. For
example, an increase of a single percentage point in the interest rate, from 6% to 7%,
1. In other countries, various central banks perform the same functions as the Fed, and they generally have the same powers.

on a $200,000 fully amortized, 30-year mortgage would increase the monthly mort-
gage payment by $131, which may cause a significant number of households with a
certain level of purchasing power to be priced out of the market for homeownership.
While the Fed determines monetary policy, the Treasury Department manages
the government’s financial activities by raising funds and paying bills. When in-
come matches spending, the federal budget is balanced. When the outflow of funds
exceeds collections, a federal deficit results. Spending that is not covered by tax funds
produces deficits, which are financed by the sale of public debt instruments such as
government bonds, bills, and notes issued by the Treasury. When deficits are mon-
etized by selling large amounts of debt, the Fed is expected, though not mandated, to
cooperate by supplying the banking system with sufficient reserves to accommodate
the debt sales program and still leave enough credit for the private sector.
Central Banking Systems and Credit Regulation

The supply of any currency and the stability of a country’s fiscal policy are regulated
by the relevant central banking system. For example, the Bank of Canada, headquar-
tered in Ottawa, monitors and manages the rate of money growth in Canada. The
Banco de Mexico performs a similar function in that country. The central banking
system in the European Union functions differently in that the European Central
Bank in Germany establishes monetary policy for the Eurozone, while the central
banks of the member states are responsible for fiscal policy in their individual coun-
tries. (Countries in the European Union that have not adopted the Euro as their unit
of currency have their own national central banks to administer monetary policy.)
The mechanisms that central banks use to influence the supply of money generally
consist of raising and lowering interest rates as well as more direct involvement in
the market to ensure price stability and access to credit.
The US Federal Reserve System is independent of the US Congress and the presi-
dent. This independence distinguishes it from central banks in most other countries,
which are government entities. Although the Fed is independent, it functions within
the general structure of the US Government, operating in accordance with national
economic policies.
The Federal Reserve regulates money and credit, which are the lifeblood of the
real estate industry. Therefore, appraisers should be familiar with the Fed’s day-
to-day activities as they affect the supply of money and the level of interest rates.
Because of the global nature of financial markets, the prevalence of instantaneous
communications, and the securitization of realty interests, the monetary activities
of the central bank can have an impact on real estate markets, just as they affect the
markets for stocks and bonds.
The Fed uses three principal credit-regulation devices to accomplish the duties
assigned to it by Congress:
1. Reserve requirements
2. The discount rate
3. The Federal Open Market Committee
Within statutory limits, the Federal Reserve Board can fix the amount of reserves that
member banks must maintain. If the Fed wants to restrict the money supply, it increases
deposit reserve obligations. If it wants to increase the supply, it lowers the obligations.

Banks in the Federal Reserve System can borrow from the Fed to meet reserve re-
quirements and obtain funds for their customers even in periods of great demand. To
get these loans, member banks agree to pay the Federal Reserve interest at its estab-
lished discount rate. The Fed can deny loan requests when it believes that borrowing
is not in the best interests of the national or regional economy.
The borrowing privilege is a vehicle for expanding the monetary supply. Curtail-
ing that privilege limits or contracts credit. The federal discount rate helps determine
the prime rate, the interest rate that a commercial bank charges for short-term loans
to borrowers with high credit ratings. The federal discount rate is generally about
two percentage points below the prime rate.
The Federal Open Market Committee (FOMC) is probably the most extensively
used and most potent of the Federal Reserve’s credit-regulating devices. The FOMC
buys and sells US Government securities in the open market, thereby exerting a pow-
erful influence on the supply of money and the interest rate. In fact, through its daily
operations, the FOMC maintains short-term money rates at selected target levels. In
periods of economic crisis, the Fed supplies financial markets with necessary liquidity.
Financial market participants may be guided by the opinions of experts, called
Fed watchers, who often correctly interpret and predict Fed policy by analyzing the
committee’s activities. Real estate investors and appraisers, whose success may also
depend on interpreting and forecasting financial markets, may profit from the exten-
sive information provided by Fed watchers.
Rate Relationships
Observable relationships between various instruments in the financial markets stem
from the differing interest rates, maturities, and investment risks of the various
Figure 10.2 Federal Reserve Districts
Source: www.federalreserve.gov/aboutthefed/federal-reserve-system.htm

instruments. Normally an investor in a long-term instrument is believed to assume
greater risk than an investor in a short-term instrument. Therefore, long-term instru-
ments usually offer higher yields. This situation is graphically portrayed in what has
come to be known as the normal yield curve (see Figure 10.3).
Sometimes the relationship is reversed. For example, if investors expect the
economy to slow or even decline in the long term, the yield of long-term debt instru-
ments (say, 30-year Treasuries) is lower than that of short-term debt instruments of
similar credit quality (say, 5- or 10-year Treasuries). An inverse (or “inverted”) yield
curve typically precedes a recession. In periods of high inflation, investors may be re-
luctant to take long-term positions. They fear that escalating interest rates will erode
their capital, so they try to keep their money in short-term instruments. The Federal
Reserve, however, wants to combat inflation, so it causes short-term interest rates to
rise. This action is intended to be temporary, lasting just long enough to dampen the
inflationary expectations of investors. Consequently, in inflationary times short-term
yields may be greater than long-term yields, and the yield curve is said to be in-
verted. On the other hand, if investors anticipate long-term interest rates to continue
to fall in a weak economy, they would expect long-term yield rates to be lower than
short-term yield rates, again resulting in an inverted yield curve.
Understanding rate relationships can help appraisers correlate real estate invest-
ment risk with the risks associated with actively traded capital market instruments,
providing support for market-derived discount and capitalization rates. The financial
press contains abundant pricing and yield information to facilitate this process.
Sources of Capital for Real Estate

Equity and debt investors reveal their different aspirations through their market ac-
tions. The debt investor participates in bonds or mortgages, usually pursuing conser-
vative paths in search of certain income and the repayment of principal. This type of
investor expects a priority claim on investment earnings and often looks for security
in the form of a lien on the assets involved. While a debt investor is relatively pas-
Figure 10.3 Normal Yield Curve

16% High-inflation period
15%
Low-inflation period
14%
12%
10%
10%
Rate
8%
6%
5.25%
4% 4.5%
2%
6 months 1 year 18 months 2 years 30 months
Term

Inflation
Inflation occurs when the general level of prices rises. The inflation rate is the rate of change in the price level
as reflected in Consumer Price Indices (CPIs). Other useful measures of inflation include the wholesale price
index and the GDP implicit price deflator.
Inflation and appreciation have similar effects on future dollars but different effects on yield rates. Inflation
tends to increase yield rates (and most rates of return) because investors require a higher nominal rate of
return to offset the loss in purchasing power due to inflation. Appreciation in property values will not affect
the yield rate unless the risk associated with the property has changed.
In oversupplied markets, real estate value may not always keep up with inflation. In an inflationary environ-
ment, the value of real estate may tend to increase with the value of other investments such as stocks and
bonds. Rents under annual leases can be adjusted upward periodically, while the interest and dividends paid
on longer-term securities are more fixed. In undersupplied commercial markets, rent spikes are sometimes
observed. These spikes allow market rents to catch up to levels that would have otherwise been achieved by
annual inflationary increases in rents. Rent spikes are generally a function of demand.
real interest rate
The economic importance of inflation can be seen in the concept of “real” interest rates. Nominal interest
rates, which are reported daily in the financial press, are said to be composites of the “real” cost of funds,
or the real interest rate, and the premiums that investors demand to protect their currency value from being
eroded by inflation. Thus, the nominal rate equals the real interest rate plus a premium for expected inflation.
Economists suggest that the real interest rate has historically remained steady at 3% to 4%. Therefore, if
the capital market were to show a nominal rate of 6% for 10-year US Treasury notes, the real interest rate
concept would indicate an inflation premium of 2%.
Nominal Rate - Real Interest Rate = Inflation Premium*
6% - 4% = 2%.
An appraiser can account for the effects of inflation in capitalization by expressing future benefits in con-
stant dollars, which are adjusted to reflect constant purchasing power, as opposed to changing dollars, which
are not adjusted. An appraiser can also express the yield rate as a real, uninflated rate of return on capital. In
practice, however, appraisers usually project income and expenses in unadjusted, inflated dollars and express
the discount rate as a nominal, or apparent, rate of return on capital that includes an allowance for inflation.
* In countries with low inflation like the United States, this formula is an adequate approximation. A more precise formula for computing the
real interest rate is
1 + Nominal Rate = 1 + Real Interest Rate

1 + Inflation Rate
1 + 0.06 = 1.03921, rounded to 1.04, or a real interest rate of 4%
1 + 0.02

sive, an equity investor is active. An equity investor
is more willing to assume risk, and the funds used for equity
equity investment are known as venture capital. An ownership claim on prop-
erty. Property value is the total
Homeowners and other owner-occupants of of debt and equity. Equity
single-unit residential property are also major sources investors assume greater risk
of capital. Homeowners invest equity, but their invest- and their earnings are subor-
ment criteria differ from those of investors in income- dinate to operating expenses
producing property. An owner-occupant trades the and debt service. They are
compensated with dividends
potential of receiving rental income for the enjoyment (cash flows) and possible
of the amenities and tax benefits provided by the appreciation in the value
property during the ownership period and the financial of their investments. Equity
benefit of the equity reversion, if any, when the house includes the residual claim
is eventually sold. to the assets, which is solely
possessed by the owners.
Equity
Equity investors realize that their earnings are subordi-
nate to a project’s operating expenses and debt service
requirements. Equity income earnings are called dividends. One year’s worth of income
from an equity investment is an equity dividend. But equity dividends are only one part
of the total return that the investor anticipates. Investors may also expect the value of
their original investment to increase, remain stable, or decrease, depending on the type
of property and market conditions. The total return the investor anticipates is called the
equity yield. An equity dividend represents the cash flow component of the equity yield.
Real Estate Investment Trusts

Real estate investment trusts (REITs) have been successful in pooling the funds of
small investors to acquire real estate investment positions that could not be handled
by these investors individually. Buying shares of REIT stock is not the same as direct
investment in a given property. REITs offer shareholders freedom from personal li-
ability, the benefit of expert management, and readily transferable shares. To qualify
for a tax pass-through, a REIT must pay dividends of at least 90% of its taxable in-
come.2 With complicated income-measuring practices, these trusts attempt to pay out
almost all their net income and, therefore, are substantially restricted in establishing
reserves for possible losses. The liquidity of these securities is an attractive feature.
When analyzing comparable sales, appraisers should consider whether a REIT
paid a premium to add the property to its portfolio. REITs tend to purchase proper-
ties with the following characteristics:
• Superior locations in superior markets
• Limited lease expiration exposure in any given year
• Improvements with minimal incurable obsolescence
• Considerable value
• Favorable management characteristics
• Long-term leases to credit tenants
2. The requirements for REITs to maintain their tax advantages are subject to change. The National Association of Real Estate Investment Trusts
provides up-to-date information on REIT regulations and trends through its website at www.nareit.org. See also Joseph L. Ferst and James R. Mac-
Crate, “NAREIT and Tax Law Changes Will Foster Consistency in Accounting Practice and Disclosure Among REITs,” The Appraisal Journal (January
2000): 14-19.

While the stock market establishes the value of REITs, the income performance
of these assets tracks that of real estate markets. REIT prices tend to be less volatile
than the Standard & Poor’s 500, and the correlation between large cap stocks and
REITs has been declining since 1990. As a result, analysts and money managers have
pointed to REITs as major diversification tools. Figure 10.4 illustrates the recent per-
formance of REITs in comparison to other investments.
Figure 10.4 Comparison of Performance of REITs and Other Investments

35
30
25
Annual Percentage Change
20
15
10
-5
2015 2016 2017 2018 2019
-10
US Treasury 10-Year Note S&P 500 Utilities
DJIA NASDAQ Composite FTSE Nareit All REITs
Source: Nareit
Partnerships
A partnership is a common vehicle for pooling real estate equity funds. It is a busi-
ness arrangement in which two or more persons jointly own a business and share in
its profits and losses.
A general partnership is an ownership arrangement in which all partners share in
investment gains and losses and each is fully responsible for all liabilities. A general
partner has complete liability for the acts of the other partners and is responsible
for debts incurred by them. This is one major disadvantage of this type of business
arrangement. The most attractive feature of a general partnership in a real estate
investment is the ability to pass the tax-shelter benefits of depreciation, interest, and
real estate taxes through to partners.
A limited partnership is an ownership arrangement consisting of general and lim-
ited partners. General partners manage the business and assume full liability for part-

nership debt, while limited partners are passive and liable only to the extent of their
own capital contributions. Limited partnerships are popular because they permit an
uneven distribution of tax-shelter benefits. Although limited partners’ financial liabil-
ity is restricted to their capital contributions, they may receive tax benefits in excess of
that amount. Limited partners may also receive a preferential return ahead of general
partners as an incentive if their participation is required to secure financing.
Joint Ventures
A joint venture is a com- Opportunity Zones
bination of two or more Opportunity zones are designed to spur economic development by
entities that join to un- providing tax benefits to investors by allowing them to defer taxes on
dertake a specific project. any prior gains invested in a qualified opportunity fund (QOF) until
Although a joint venture (a) the date on which the investment is sold or exchanged or (b) until
Dec. 31, 2026, whichever comes first. There is a 10% exclusion of
often takes the form of a the deferred gain for QOF investments held for more than five years.
general or limited part- When the investment is held for more than seven years, the exclusion
nership, it differs from a is 15%, and when the investment is held for ten or more years, the
partnership in that it is investor is eligible for a permanent exclusion from taxable income of
intended to be temporary capital gains from the sale or exchange of that investment.
The rules and regulations for this economic development tool are
and project-specific. The evolving, and valuation-related questions are materializing as market
parties may later embark activity within opportunity zones begins. One issue could involve the
on other ventures, but use of a sale from outside an opportunity zone as a comparable for
each venture is the sub- one inside an opportunity zone and vice versa. Additionally, data lags
ject of a separate contrac- may necessitate fully informed market condition adjustments. Ap-
praisers will also likely be asked to segregate building value and land
tual agreement. value for tax planning purposes.
A joint venture ar- The IRS provides information on opportunity zones at www.irs.gov/
rangement is frequently newsroom/opportunity-zones-frequently-asked-questions.
used in large real estate
projects. One party, usu-
ally a financial institu-
tion, supplies most of the required capital and the other party provides construction
or management expertise. Life insurance companies and pension trusts have joined
with entrepreneurial building organizations in joint ventures to develop large offices,
shopping malls, and other major real estate projects.
Pension Funds
Private and government-operated pension funds are a huge source of investment
capital. Usually the pension contributions of employers and employees are placed
with a trustee, who is obliged to invest and reinvest the money prudently, accumu-
late funds, and pay designated plan benefits to retirees. The trustee may be a govern-
ment body, a trust company, an insurance company, or an individual. In performing
these duties, an individual trustee may employ the trust departments of commercial
banks, insurance companies, and other financial institutions.3
Traditionally, pension funds have been involved primarily in securities invest-
ments such as stocks and bonds. The development of pass-through securities by Gin-
3. To protect American workers covered by pension and other benefit plans, Congress adopted the Employee Retirement Income Security Act (ERISA) in
1974 and later the Pension Protection Act of 2006. ERISA and its subsequent amendments establish a comprehensive legislative framework governing
the investment, management, and administration of employee pension plans, profit-sharing plans, and welfare plans. ERISA also empowers government
agencies to conduct audit programs in performing their duties. After more than three decades, the administrative structure and doctrine of ERISA continue
to evolve as the courts and regulatory agencies make judgments concerning compliance by plan administrators and the claims due beneficiaries.

nie Mae, however, has made it easier for pension funds to invest in mortgages, and
they have made sizable investments. Pension trusts have also shown a willingness to
invest in real estate equities by purchasing or participating in the real estate invest-
ments created by life insurance companies and commercial banks. Banks and life
insurance companies acquire high-quality real estate equities, pool the investments in
separate accounts, and supply the necessary portfolio management for a fee. Pension
trusts commit funds to these accounts and share in all earnings, which consist of both
income returns and sales profits. The real property holdings of a pension fund may
be in a separate account or in a commingled fund with other investments.
Life Insurance Companies

Life insurance companies have always invested heavily in real estate. Their activities
include both mortgage lending (debt) and property ownership (equity investment).
Life insurance companies usually acquire real estate positions that are long-term and
relate well to their regular business, in which policy premiums are collected over
extended periods. Their investment officers regard equities as attractive earning
situations that offer growth potential and reasonable protection against the capital
erosion caused by inflation.
Hedge Funds
A hedge fund is a type of private investment fund with a controlled pool of investors
that is usually structured as a limited partnership or limited liability company and is
managed privately. In contrast to conventional equity funds such as mutual funds,
hedge funds are not subject to official banking rules. Traditionally, hedge funds have
sought out short-term, often high-risk and high-leverage investment opportunities
that public funds cannot pursue. Hedge funds entered the real estate marketplace
prior to the financial crisis by targeting retailers with undervalued real estate assets
that can be sold or leased back to the retailer. Since then, hedge funds have emerged
as an alternative to the traditional capital sources, which have tightened risk manage-
ment controls since the financial crisis. Distressed properties with a potential finan-
cial upside and below-investment-grade real estate securities are the sorts of high-
risk real estate investments that hedge funds are able to invest in.
International Equity Capital

Although foreign investors represent only a very small fraction of the total direct real
estate investment in the United States, they supply needed equity capital to realty
ventures when traditional sources of capital are reluctant to invest. The globaliza-
tion of financial markets has eliminated some of the obstacles to foreign investment,
although international exchange rates still have a significant effect on the relative
purchasing power of different currencies.
International capital comes from a variety of sources, such as foreign individuals,
financial institutions, and pension funds. Sovereign wealth funds have emerged as
significant equity investors. A sovereign wealth fund is a state-owned public invest-
ment agency that manages a portfolio of foreign assets to improve the return on
traditional foreign exchange reserves. Resource-rich countries have sought opportu-
nities to protect their wealth from fluctuations in the prices of commodities like oil
by investing in assets like real estate with more stable long-term financial prospects.
In the past, sovereign wealth funds were known to pursue trophy properties, but

since the financial crisis they have concentrated on distressed real estate assets, often
investing through other funds rather than directly.
Overall, foreign investment in US businesses and housing declined in the early
days of the recession but bounced back over the course of the next decade. In 2018,
the roughly $95 billion in foreign investment in US real estate approached the 2015
peak of $100 billion, despite a 60% drop in Chinese investment due to changes in
government controls of outward-bound capital. Both European and Asian buyers
perceived the United States as a safe place to invest, although an increase in hedging
costs to guard against potential fluctuations in the value of the dollar have affected
the capital flow into the country. Some international investors have sought higher-
yield investments outside the traditional central business district (CBD) target mar-
kets to make up for these hedging costs.
Debt debt
Because mortgage money is so important in real estate, One of two characteristic
investors, appraisers, and analysts must be familiar types of capital, the other
being equity. The debt investor
with the sources and costs of debt capital. The primary
expects a priority claim on in-
market of direct investors includes the traditional real vestment earnings and looks
estate lenders: commercial banks, community banks, for security in the form of a
life insurances companies, and others. The secondary lien on the assets involved
mortgage market has historically been dominated by and the promise to repay.
Debt investors may participate
government-sponsored enterprises (GSEs) like Fannie
in bonds or mortgages and
Mae and Freddie Mac, although private entities have receive fixed or variable inter-
increased their participation through the purchase of est on the investment with
securitized real estate debt. repayment of the principal
upon maturity. In amortizing
Commercial Banks loans, some principal is paid
Commercial banks are privately owned institutions periodically as well.
that offer a variety of financial services to businesses
and individuals. In keeping with their role as short-
term lenders, commercial banks have traditionally
supplied construction and development loans. For short-term, interim financing,
developers are usually required to obtain commitments from long-term, permanent
lenders, whereby the lenders agree to “take out” the “end loan” with the developer
once the project has been completed. Large commercial banks have also become a
principal source of takeout financing, i.e., long-term permanent mortgage loans and
end loans, usually for commercial and industrial properties. In small communities,
commercial banks such as Wells Fargo and Bank of America are also expected to sup-
ply their customers with home loans.
Community Banks
Community-based financial institutions are generally smaller than commercial banks
(i.e., community banks have less than $1 billion in assets), but community banks hold
a larger proportion of commercial real estate loans as a percentage of their balance
sheets, often as much as 50%. Prior to the financial crisis, community banks were able
to reduce their risk by selling much of their mortgage portfolios to government-spon-
sored entities in the secondary mortgage market or to larger, commercial banks. With
consumer lending being dominated by commercial banks in recent years, community

banks have tended to focus on lending for construction and development and loans
secured by multifamily properties, farmland, and nonresidential nonfarm properties.
Even though community banks did not hold the sort of securities associated
with the financial crisis, they were still hard hit by the poor performance of commer-
cial real estate loans in the following years. From 2008 to 2011, 85% of bank failures
involved institutions with less than $1 billion in assets, which often concentrated on
small business lending and were associated with local community development.4
Commercial banks are more prevalent in metropolitan areas than community
banks. As a result, community banks have not been able to take advantage of the
relatively stronger economic growth of metropolitan areas to grow as quickly as
banks headquartered in those areas. However, structural changes in the US economy,
which are shifting economic output from the areas that experienced high growth
prior to the financial crisis, may allow community banks to grow at a similar rate as
commercial banks in the near future.
Life Insurance Companies

The mortgage investments of life insurance companies cover the full range of realty
types—e.g., residences, apartments, offices, shopping malls, hotels, and industrial
properties. Because many life insurance companies have great financial resources,
they have been important in mortgaging large, income-producing properties. Large
companies prefer loans on commercial properties.
Mutual Savings Banks

Mutual savings banks are very similar to mutual savings and loan associations, pro-
moting thrift and investing substantial amounts of savings in real estate mortgages.
Generally, they have broader investment powers than savings and loan associations.
Savings banks concentrate on mortgages, but they also invest in government bonds,
corporate bonds, and, to a lesser degree, real estate and stock equity investments.
Junior Mortgage Originators

Junior mortgages can be used to raise substantial amounts of mortgage funds and to
achieve various investment goals, such as creating additional leverage and facilitating
sales of properties with first mortgages that cannot be refinanced. Junior mortgages
involve greater risk than senior liens do and therefore command higher interest rates.
Hard Money Lenders

Hard money loans are most often used as bridge loans or in distressed financial situ-
ations. They are commonly made by private companies or individuals, who focus
almost exclusively on the security interest in the property as opposed to the credit
worthiness of the borrower. This market is typically unregulated, offering flexibility
and a streamlined approval process. Hard money loans generally have relatively
short terms and carry higher interest rates to accommodate increased risk. The
market for hard money loans has increased since passage of the Dodd-Frank Act in
2009, which increased the regulation of conventional lenders. Because underwriting
is primarily focused on the security interest in the underlying asset, valuation of the
property is of major importance.
4. US Government Accountability Office, “Causes and Consequences of Recent Bank Failures,” Report to Congressional Committees GAO-13-71
(January 2013).

Secondary Mortgage Market Figure 10.5 The Primary and Secondary Mortgage Markets
Government and private
organizations stimulate Primary Market Secondary Market
home building through
the secondary mortgage Lender Sells Transfer agent for:
market (Figure 10.5). mortgage • Fannie Mae
In this market, mort- Sends • Freddie Mac
gagees sell packages monthly
Mortgage • Ginnie Mae
Funds
of mortgages at prices payments • Farmer Mac
consistent with existing Sells
money market rates. Sell- mortgage
Borrower
ing mortgages frees up
capital, creates liquidity, Investor
and permits mortgagees
to lend when they might
otherwise lack funds.
Although most secondary mortgage market activity is generated by Fannie Mae,
Freddie Mac, and Ginnie Mae, the private sector has also played a role. Banks and
insurance companies with mortgage-originating capability often sell loan portfolios,
or mortgage participations, to private or institutional investors. Some REITs have
purchased mortgages from institutions, thereby supplying the sellers with the liquid-
ity needed to continue their lending programs.
Securitization of Real Estate Investment Markets

Securities are investment instruments that convey ownership in certificates backed
by mortgage payments of properties in the securitized mortgage pool. The pools are
divided into tranches of varying levels of risk, as determined by rating agencies.
The emergence of collateralized mortgage obligations (CMOs) as a major invest-
ment banking instrument was prompted by Ginnie Mae guarantee arrangements.
CMOs are bonds issued and sold in the capital markets. They are attractive to inves-
tors because the debt involved is usually collateralized by Ginnie Mae certificates
covering pools of residential mortgages. Prior to the financial crisis, this vehicle was a
huge source of liquidity for the mortgage industry and helped monetize the mortgage
element in real estate investment. (See Figure 10.6.)
The real estate mortgage investment conduit is a variation in the CMO field. A real
estate mortgage investment conduit (REMIC) transforms the CMO from a pure debt
(bond) vehicle into an equity-type investment. In a REMIC arrangement, the certificate
represents a proportionate share of ownership in a pool of mortgages. The issuing or-
ganization, often an investment bank, avoids adding debt to its balance sheet by using
the REMIC. The investor in a REMIC enjoys the benefit of a tax pass-through similar to
that of a REIT, and thereby avoids the double taxation incurred by investors in corpora-
tions. CMOs of all types brought enormous amounts of capital into the mortgage field.
Collateralized debt obligations (CDOs) differ from CMOs in that the assets used
as security are not mortgages. The collateral usually consists of loans and debt instru-
ments, sometimes a mixed portfolio, divided into tranches of different risk levels and
a decreasing priority of claims. Since the 1990s, CDOs have been a primary driver of
the growth in the securitization of real estate globally, and they are often identified as

Figure 10.6 United States CMBS Issuance by Year
250
230
203
200
168
150
Billions
94 95
100 90 86
78 80
66 68
54 53
50 48 44
30
12 11
3
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Source: http://www.crefc.org/CREFC/Resources/Compendium_of_Statistics/CMBS_Issuance.aspx
a prime culprit in the subprime mortgage crisis. The vilified credit default swap is a
credit derivative in which the buyer makes periodic payments to the seller and, in re-
turn, receives payment if an underlying financial instrument (often a CDO) defaults.
Although considered a form of insurance, credit default swaps were mostly unregu-
lated prior to the financial crisis. Subsequent reforms have increased transparency,
but credit default swaps are still subject to considerable speculation.
Debt and Equity Relationships

In the capital markets, when the risks associated with different investments are
comparable, funds flow to the investment that offers the best prospective yield. Risks
are related to rewards. If capital is to be attracted, competitive yields must be offered.
Security vs. Real Estate

Although public market pricing has some advantages, investor-driven pricing does not necessarily reflect the
value of the underlying real estate asset. There is wide variation among real estate securities, depending on
the structure of the particular investment vehicle. For example, REITs are subject to stringent requirements
as to the dividends paid to investors (expectations of higher or lower dividends can influence pricing) or to
legal restrictions limiting the amount of property that can be sold in any given year. REITs can also employ
investment leverage, which increases the potential return on the investment but can create difficulties for the
investment in market downturns.
In the 1990s, the first property derivatives were developed as financial instruments that allowed owners to
hedge risk in property portfolios and investors to participate in the real estate market without direct invest-
ment in specific properties. The pricing mechanism for derivatives is an underlying property index. During
the financial crisis of 2008, the complexity and lack of transparency of the property derivative structure was
criticized as obscuring the risks involved for individual investors and for the health of the market as a whole.

Principal Operators in the Secondary Mortgage Market
In the United States, activity in the secondary mortgage market has historically been dominated by a handful
of government and quasi-governmental agencies. Government-sponsored enterprises (GSEs) like Fannie
Mae, Freddie Mac, and the other participants in the secondary mortgage market are regulated by the federal
government. The various GSEs have different investment strategies and levels of governmental involvement,
but all help to make funds available for home buyers and renters.
Fannie Mae and Freddie Mac
The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corpora-
tion (Freddie Mac) are quasi-governmental corporations that engage in certain business activities to ensure
liquidity in the mortgage market:
• Purchasing existing mortgages from banks, trust companies, mortgage companies, savings and loan as-
sociations, and insurance companies
• Guaranteeing that the mortgages it holds will be paid on time
• Pooling the mortgages into mortgage-backed securities
• Either holding or selling the securities to other investors
In 2008, the federal government took conservatorship of Fannie Mae and Freddie Mac in an effort to
stabilize the secondary mortgage market during the financial crisis. In a 2011 white paper on mortgage
finance reform, the Obama administration proposed the eventual dissolution of the government-sponsored
enterprises. The proposal would shift support of mortgage credit from government to private markets through
increased guarantee-fee pricing as well as larger down payment requirements. The two GSEs and the Federal
Housing Administration support more than 90% of new American home loans. The Treasury report proposed
that the government’s main roles should be consumer protection, “robust oversight” of lenders, and assis-
tance to low- and middle-income American homeowners and renters. The proposal called for replacing Fannie
and Freddie with a federal guarantee in one of three ways:
1. The FHA, Department of Agriculture, and the Department of Veterans Affairs would be the only agencies
offering such guarantees.
2. The FHA and a federal government backstop would offer guarantees only in the event of economic stress.
3. The federal backstop would remain in place at all times, regardless of market conditions.
Various options remain for any eventual restructuring of the GSEs, such as taking the organizations out of
conservatorship and back into private ownership as stockholder-owned corporations, splitting the two large
GSEs into a larger number of smaller entities, absorbing the GSEs into the government again, and others.*
In 2013, the Federal Housing Financing Agency (FHFA) announced plans to form a new company that
would consolidate back-office functions of the two GSEs. The long-term goals for Fannie Mae and Freddie
Mac expressed by the FHFA leadership are to gradually contract the dominant presence of the GSEs in the
marketplace and shrink their operations, to build a new infrastructure for the secondary mortgage market,
and to maintain current activities that promote market stability and liquidity and help prevent foreclosure.†
Ginnie Mae
The Government National Mortgage Association (GNMA) is a federally owned and financed corporation under
the Department of Housing and Urban Development that subsidizes mortgages through its secondary mort-
gage market operations and issues mortgage-backed, federally insured securities. Its most important program
is the mortgage-backed security program in which Ginnie Mae guarantees securities covered by pools of loans
collected by mortgage originators. Ginnie Mae deals only with FHA, VA, and Rural Housing Administration loans.
Farmer Mac
The Federal Agricultural Mortgage Corporation is a federally chartered, but privately owned, corporation that
serves the same function for rural properties as Fannie Mae and Freddie Mac do for urban and suburban
properties. Its most important programs are the secondary mortgage market programs for agricultural real
estate and rural housing.
* See also N. Eric Weiss, Fannie Mae’s and Freddie Mac’s Financial Status: Frequently Asked Questions, CRS Report for Congress (Washington,
DC: Congressional Research Service, 2012).
† Edward J. DeMarco, “FHFA’s Conservatorship Priorities for 2013,” Remarks as Prepared for Delivery, National Association for Business
Economics 29th Annual Economic Policy Conference, Washington, DC (March 4, 2013).

The most persuasive indicators of competitive yield levels are found in money mar-
kets where billions of dollars of capital are traded daily, traders are sophisticated and
well informed, and investments are often professionally rated for risk.5
In an unstable economic climate, appraisers are well advised to collect data on the
capital markets to support the conclusions they have developed from real estate mar-
ket data. The transactions in the financial markets reflect the discounting of economic
futures by well-informed investors and provide useful insights for investment analysts.
The largest equity market is the trading of common stocks. Transactions are
reported daily, and share prices and current dividend rates are revealed. Financial
publications and online sources offer abundant information about corporate earn-
ings and general conditions in commercial and industrial enterprises. This data
provides the basis for risk rating of the securities issued by businesses. In the field
of debt investments (bonds and debentures), the rating task is often performed by
professionals such as Standard & Poor’s, Moody’s, Duff & Phelps, and Fitch Ratings.
Their opinions are widely published. Other information is furnished by the securi-
ties analysts of major banking institutions, brokerage companies, and the investment
banking industry. Their opinions are readily available to investors.
Types of Risk
Every real estate transaction contains an element of risk. A lender accepts the risk that a borrower may
default on a loan. A landlord accepts the risk that tenants will not renew at the termination of a lease. Home
buyers accept risks related to the quality and condition of unseen building elements and, on a larger level,
the likelihood that property values in the neighborhood will go up or down in the future. Risk increases as the
range of possible outcomes grows. The rate of return necessary to attract investment increases along with risk
levels.
Various types of risk can affect an investment:
Market risk
Definition: Risk that net operating income will be affected by changes in the market—e.g., shifts in
demand or supply or both
Influenced by: • Type of property
• Location of property
• Stage in cycle
Financial risk
Definition: Risk related to the use of debt to finance an investment (e.g., default, prepayment, contrac-
tual financing terms that cannot respond to interest rate changes)
Influenced by: • Amount of debt
• Type of debt
Capital market risk
Definition: Risk that market value will be affected by changes in capital markets—e.g., mortgage yield
rates, equity yield rates, overall yield rates (due to the changes in mortgage or equity yield
rates), or overall and terminal capitalization rates (due to changes in overall yield rates)
Influenced by: • Changes in levels of interest rates
• Changes in availability of capital (both mortgage and equity)
• Rate of return for alternative investment opportunities
5. For publications and research from the ratings agencies on the performance of stocks and bonds, see www.standardandpoors.com, www.moodys.
com, www.duffandphelps.com, and www.fitchratings.com.

Investment Yields
There are differences in the investment yields produced by debt and equity instru-
ments. With a debt instrument, the original lender is entitled to interest at a specified
rate, either fixed or variable, and full payment of the loan amount at maturity. The
arrangement may call for periodic payments of interest only and full repayment of
the principal at maturity, as in the case of bonds, or it may require periodic payments
that combine interest and debt reduction, as in most mortgage loans.
An equity investment has none of the contractual certainty or specificity of a debt
position. The income or dividend earnings are simply the amount of a venture’s in-
come, if any, after operating expenses and debt service are paid. This cash flow can be
positive or negative, depending on whether there is an excess or deficiency of income
after all expenses. The reversion is simply the venture’s market value at the end of
the investment holding period—i.e., a future value. When entering into an invest-
ment, an investor considers the forecast dividend earnings and reversion in relation
to the acquisition price. This relationship reflects the prospective equity yield. Upon
Types of Risk (continued)

Inflation (purchasing power risk)
Definition: Risk that unexpected inflation will cause cash flow from operations and reversion to lose
purchasing power
Influenced by: • Lease provisions that provide inflation protection
Liquidity (marketability) risk
Definition: Difficulty of converting a real estate investment into cash at market value in a reasonable
time
Influenced by: • Inefficiency of real estate market
• Strength or weakness of the market
Environmental risk
Definition: Risk that the market value of a property will be affected by its physical environment
Influenced by: • Perceived health hazards
• Costs associated with dealing with potential environmental problems
• Acts of nature such as earthquakes and weather conditions
Legislative risk
Definition: Risk that legal factors will affect the market value of a property
Influenced by: • Tax law changes
• Environmental regulations
• Change in land use regulations (zoning)
• Ability to navigate permitting process
Management risk
Definition: Risk that the management cannot ensure that the property meets defined goals
Influenced by: • Competency of management
• Type of property (e.g., regional malls require more intensive management than
warehouses)
Each of these types of risk can influence a property separately or in combinations. For example, a change
in federal tax laws (legislative risk) may lead to changes in the required equity yield rate (capital market risk),
or unexpected inflation (inflation risk) can cause mortgage interest rates to rise (capital market risk).
Comparable properties in the income capitalization approach should have the same degree of risk as the
subject property because risk is a consideration in the selection of overall capitalization and yield rates.

termination of the investment, the dividends and reversion realized are related to the
original amount of the investment to reflect the historic equity yield.
Leverage
The term leverage refers to how borrowed funds increase or decrease the equity re-
turn. The leverage an investor obtains by using borrowed funds to finance an invest-
ment is accompanied by risk. The investor seeks compensation for this risk by requir-
ing a higher equity yield rate. In analyzing cash flows, positive leverage is indicated
when the overall capitalization rate is greater than the mortgage capitalization rate.
The difference between the two rates directly benefits the equity owner, so the equity
capitalization rate is higher than it would be if there were no mortgage. The same
relationships hold for overall, equity, and mortgage yield rates. (See Table 10.4.)
The analysis of leverage is important because positive or negative leverage
can affect the level of risk associated with a real property investment and the yield
required to satisfy an investor willing to assume the risk. The use of leverage magni-
fies fluctuations in cash flow, and enhanced variability translates into risk. If property
performance falls below expectations and periods of insufficient cash flow are pro-
tracted, the investor may become strapped for cash to service the debt on the prop-
erty, a situation many real estate investors encountered as prices of highly leveraged
properties dropped following the financial crisis of 2008. If market conditions become
illiquid, investors may be unable to command a price for property that allows for
repayment of the debt.
Table 10.4 Types of Leverage

Leverage Is Using Equity Capitalization Rates Using Equity Yield Rates
Positive If the overall capitalization rate is greater If the overall yield rate is greater than the
than the mortgage capitalization rate, then mortgage yield rate, then the equity yield rate is
the equity capitalization rate is greater than greater than the overall yield rate.
the overall capitalization rate
Neutral If the overall capitalization rate is equal to If the overall yield rate is equal to the mortgage
the mortgage capitalization rate, then the yield rate, then the equity yield rate is equal to
equity capitalization rate is equal to the the overall yield rate.
overall capitalization rate.
Negative If the overall capitalization rate is less than If the overall yield rate is less than the mortgage
the mortgage capitalization rate, then the yield rate, then the equity yield rate is less than
equity capitalization rate is less than the the overall yield rate.
overall capitalization rate.

Neighborhoods, Districts, and 11
Market Areas
Buyers and sellers of different property types interact in different areas for various
reasons. Real estate markets are divided into categories based on property types and
their appeal to different market participants. The markets for various categories of
real estate are further divided into submarkets, which correspond to the preferences
of buyers and users. Differentiating real estate markets into market segments facili-
tates their study.
All real estate markets are influenced by the attitudes, motivations, and interactions
of buyers and sellers of real property, which in turn are subject to many social, eco-
nomic, governmental, and environmental influences. Property values are also affected
by the four factors of value: utility, scarcity, desire, and effective purchasing power. Real
estate markets may be studied in terms of their geographic, competitive, and supply-
and-demand characteristics, which relate to overall real estate market conditions.
The identification and interpretation of real estate markets are analytical pro-
cesses. To answer questions about real estate markets and market segments, apprais-
ers analyze the utility and scarcity of property as well as the desires and effective
purchasing power of those who seek to acquire property rights. For example, the
many lender-owned residential properties that became available after 2008 could not
be purchased by typical owner-users because they were not able to get the financing
needed to improve the properties and make them habitable.
Characteristics of Real Estate Markets

A real estate market consists of a group of individuals or firms that are in contact
with one another for the purpose of conducting real estate transactions. Possible mar-
ket participants include the following:
• Buyers
• Sellers
• Landlords (lessors)
• Tenants (lessees)
• Lenders (mortgagees)
submarket
• Borrowers (mortgagors)
A division of a total market
that reflects the preferences • Developers
of a particular set of buyers • Builders
and sellers.
• Property managers
market segmentation
The process by which • Owners
submarkets within a larger • Investors
market are identified and • Brokers
analyzed.
disaggregation • Attorneys
Grouping the subject and Each market participant does not have to be in contact
competitive properties with every other participant. A person or firm is part
together based on similar of the market if that person or firm is in contact with
attributes or characteristics.
another subset of market participants.
The actions of market participants are prompted
by their expectations about the uses of a property and
Specific real estate markets the benefits that property will offer its users. Market
can be identified by property segmentation, therefore, differentiates the most prob-
type, property features, mar- able users of a property from the general population by
ket area, substitute proper- their consumer characteristics. The activity of individual
ties, and complementary market participants in a real estate market focuses on
properties.
a real estate product and the service it provides. Prod-
uct disaggregation, therefore, differentiates the subject
property and competitive properties from other types of
properties on the basis of their attributes or characteristics.
A market segment is delineated by identifying the market participants likely to
be interested in the subject real estate and the type of real estate product or service it
provides. Product disaggregation includes both the subject property and competitive
and complementary properties. Thus, market analysis combines market segmenta-
tion and product disaggregation. The characteristics of a subject property and its
market area that are investigated in the process of delineating the market are illus-
trated in Figure 11.1.
An appraiser should include only relevant data in analyzing the market and
preparing the appraisal report. For example, an appraisal report for an apartment
property should not include a detailed market analysis of the retail and office prop-
erty markets and fail to provide a thorough analysis of the apartment market. An ap-
praisal report should identify whether the market for the property is local, regional,
or national.
Market Areas, Neighborhoods, and Districts

Social, economic, governmental, and environmental forces influence property values
in the vicinity of a subject property. As a result, they affect the value of that property.
Therefore, to conduct a thorough analysis, appraisers must delineate the boundar-
ies of the area of influence. Although physical boundaries may be drawn, the most
important boundaries are those that identify factors influencing property values.
The area of influence, commonly called a neighborhood, can be defined as a group
of complementary land uses. A residential neighborhood, for example, may contain

Figure 11.1 Market Delineation Process
To identify a specific real estate market, an appraiser investigates the following factors:
1. Property type (e.g., single-unit residence, retail shopping center, office building).
2. Property features such as occupancy, customer base, quality of construction, and design and amenities.
a. Occupancy—single-tenant or multitenant (residential, apartment, office, retail).
b. Customer base—the most probable users. Data on population, employment, income, and activity patterns is
analyzed. For residential markets, data is broken down according to the profile of the likely property owner or
tenant. For commercial markets, data is segmented according to the likely users of the space. For retail mar-
kets, the clientele that the prospective tenants will draw represents the customer base. For office markets, the
customer base reflects the space needs of prospective companies leasing office units.
c. Quality of construction (class of building).
d. Design and amenity features.
3. Market area—defined geographically or locationally. A market area may be local, regional, national, or international
in scope. It may be urban, suburban, or rural. It may correspond to a district or neighborhood of a city. Retail and
residential market areas are often delineated by specific time-distance relationships.
4. Available substitute properties—i.e., equally desirable properties competing with the subject in its market area,
which may be local, regional, national, or international.
5. Complementary properties—i.e., other properties or property types that are complementary to the subject. The users of
the subject property need to have access to complementary properties, which are also referred to as support facilities.
single-unit homes and commercial properties that provide services for local resi-
dents. A district, on the other hand, has one predominant land use. Districts are com-
monly composed of apartments, commercial, industrial, or agricultural properties.
In broader terms, appraisers analyze the market area within which a subject property
competes for the attentions of buyers and sellers. A market area can encompass one
or more neighborhoods or districts or both.
The term market area may be more relevant to the valuation process than either
neighborhood or district for several reasons:
• Using the umbrella term market area avoids the confusing and possibly negative
implications of the other terms.
• A market area can include neighborhoods, districts, and combinations of both.
• Appraisers focus on market area when analyzing value influences. A market area
is defined in terms of the market for a specific category of real estate and thus
is the area in which alternative, similar properties effectively compete with the
subject property in the minds of probable, potential purchasers and users.
To identify a market area’s boundaries, an appraiser examines the subject prop-
erty’s surroundings. The investigation begins with the subject property and proceeds
outward, identifying all relevant actual and potential influences on the property’s
value that can be attributed to the property’s location. The appraiser extends the
search far enough to encompass all of the influences the market indicates will affect
a property’s value. When no more factors that would affect the value of the subject
property and of surrounding properties are found, the boundaries for analysis are
set. An appraiser’s conclusions regarding the market area’s impact on a property’s
value are meaningful only if area boundaries have been properly drawn.
Analyzing the market area helps to provide a framework, or context, in which
the opinion of property value is developed. The analysis identifies the area of influ-
Neighborhoods, Districts, and Market Areas 139

ence and establishes potential limits within which an appraiser searches for data that
can be used to apply the approaches to value. Analyzing the market area also helps
an appraiser determine an area’s stability and may indicate future land uses and
value trends.1
The Life Cycle of Real Estate Markets

Real estate markets are dynamic, and appraisers describe this quality as a market’s
life cycle. The complementary land uses that make up neighborhoods and the homo-
geneous land uses within districts typically evolve through four stages:
1. Growth—a period during which the market area gains public favor and accep-
tance
2. Stability—a period of equilibrium without marked gains or losses
3. Decline—a period of diminishing demand
4. Revitalization—a period of renewal, redevelopment, modernization, and increas-
ing demand
Transition often occurs in the revitalization stage, when a land use that is no longer
financially feasible is discontinued in favor of a more productive use.
Although these stages can describe the life cycle of market areas in a general way,
they should not be used as specific guides to market trends. No set number of years
may be assigned to any stage in the cycle. Many real estate markets remain stable for
a long time, and decline is not necessarily imminent in all older areas. Unless decline
is caused by a specific external influence—e.g., natural disaster, major economic
event—it may proceed at an imperceptible rate and can be interrupted by a change
in use or a revival of demand. A market has no set life expectancy, and the life cycle
Figure 11.2 The Real Estate Market Cycle

Expansion: Sustained Decline: Positive but
growth in demand, falling demand,
increasing construction increasing vacancy
Price
Recession: Falling Recovery: Increasing

demand, increasing demand, decreasing
vacancy vacancy
1. What has traditionally been called neighborhood analysis is referred to in this text as market area analysis, in part to distinguish that concept
from market analysis, which is covered in Chapters 15 and 16. Market area analysis focuses on the identification of a market area’s boundaries
and the social, economic, governmental, and environmental influences that affect the value of real property within those boundaries. In conducting
market analysis, appraisers address the competitive supply and demand for the subject property more directly.

is not an inevitable progression. At any point in the cycle, a major change can inter-
rupt the order of the stages. For example, a strong negative influence such as a major
employer suddenly pulling out of a community or the closing of a military base can
cause a real estate market that is growing to decline rather than stabilize.
After a period of decline, a real estate market may undergo a transition to other
land uses, or its life cycle may begin again due to revitalization. Revitalization often
results from organized rebuilding or restoration undertaken to preserve the architec-
ture of significant structures. It may also be caused by a natural resurgence of de-
mand. The rebirth of an older, inner-city neighborhood, for example, may simply be
due to changing preferences and lifestyles.
Defining Geographical Boundaries

The boundaries of market areas, neighborhoods, and districts identify the areas that
influence a subject property’s value. These boundaries may coincide with observ-
able changes in land use or demographic characteristics. Physical features such as
structure types, street patterns, terrain, vegetation, and lot sizes help to identify land
use districts. Transportation arteries (highways, major streets, and railroads), bodies
of water (rivers, lakes, and streams), and changing elevation (hills, mountains, cliffs,
and valleys) can also be significant boundaries.
To identify the boundaries of a market area, an appraiser
1. Examines the subject property. The process of defining a market area’s boundar-
ies must start with an analysis of the subject property.
Change and Transition in Real Estate Markets

In the analysis of a real estate market, appraisers recognize the potential for change and try to determine
how an area may be changing. Appraisers consider trends in market growth and composition when analyzing
patterns of change. They also investigate whether a market is in a state of transition from one type of land
use to another, which, although related to the principle of change, is a separate concept.
In essence, transition is the result of change. For example, the arrival of a major new employer in a market
may cause a change in demand for residential property, and that change in market conditions may then lead
to the transition of formerly undeveloped land within the market to a more intensive use as the site of new
homes or apartments.
Transition is often indicated by variations within the neighborhood or market area. New uses may indicate
potential increases or decreases in property values. For example, a residential neighborhood in which some
homes are well maintained and others are not well maintained may be undergoing either decline or revitaliza-
tion. The introduction of different uses, such as residential apartments or offices, into a single-unit residential
neighborhood may also indicate potential transition to a more intensive use.
Changes in one market area are usually influenced by changes in other, competing areas and in the larger
region of influence. The growth of one market area may lead to the downfall of a competing market area. Sub-
urban business centers may interfere with the success of a city’s central business district. Newer residential
areas may affect older areas. The added supply of new homes may cause residents to shift from old homes
to new ones and place older homes on the market. This increase in supply may affect the market values of
all homes in the area. If an area’s location makes it attractive for conversion to more intensive land uses, the
existing improvements in that area may be remodeled or torn down to make way for redevelopment.
Guide Note 12 to the Standards of Professional Practice of the Appraisal Institute includes discussion of mar-
ket evidence of changing markets. For example, signs of a bubble market include prices increasing more quickly
than rents, shorter marketing times, and an increase in the number of properties remaining vacant after purchase.
Evidence of a bust market includes an increase in the rate of foreclosures and a tightening of credit markets.

2. Examines the area’s physical characteristics. An appraiser should drive or walk
around the area to develop a sense of place, noting the degree of similarity in
land uses, structure types, architectural styles, and maintenance and upkeep.
Using a map, an appraiser can identify points where these characteristics change
and note any physical barriers—e.g., major streets, hills, rivers, railroad tracks—
that coincide with these points.
3. Determines preliminary boundaries on a map. An appraiser determines geospa-
tially the area to connect the points where physical characteristics change.
4. Determines how well the preliminary boundaries correspond to the demographic
data. The market area boundaries are often overlaid on a map of geographi-
cal areas (e.g., zip codes, census tracts, block groups). An appraiser’s observed
market area and the areas for which data is available seldom match up perfectly.
The information available for census tracts, zip code regions, and counties must
be segmented to delineate pertinent submarkets.2 Reliable data may also be avail-
able from local chambers of commerce, universities, and research organizations,
often through online sources.
An appraiser might consider surveying area residents to identify relevant charac-
teristics. Appraisers may also interview business people, brokers, and community
representatives to establish how far they think the market area extends. Through
experience, an appraiser learns to observe changes and recognize how market areas
are perceived by their inhabitants.
Legal, political, and
economic organizations
Defining Districts collect data for stan-
In defining a district, variations in the relevant characteristics of proper- dardized or statistically
ties may indicate that more limited boundaries should be established defined areas such as cit-
than for a market area. For example, consider an urban area where many ies, counties, tax districts,
high-rise apartment buildings are constructed along a natural lakeshore
and separated from other land uses by major transportation arteries. In census tracts, and special
this type of district, there may be great variations in apartment prices, enumeration districts.
sizes, views, parking availability, proximity to public transportation, and Although this data may
building ages. These variations suggest limited district boundaries that be relevant, it rarely con-
must be identified to reveal market and submarket characteristics. forms to the market area
boundaries identified
for property valuation.
If such secondary data is used to help identify market area boundaries, an appraiser
should verify and supplement the data with primary research.
Value Influences in Real Estate Markets

As mentioned previously, the four forces that influence value (i.e., social, economic,
governmental, and environmental forces) interact in the marketplace, creating unique
combinations of factors. Careful study of general data related to a real estate market’s
character is a prerequisite to the more formal application of market analysis, highest
and best use analysis, and the approaches to value.
2. Every 10 years the Bureau of the Census of the US Department of Commerce collects data on population and housing characteristics, employment,
and earnings. For information on applying US census and other data to the analysis of market areas, see Stephen F. Fanning, Market Analysis for
Real Estate: Concepts and Applications in Valuation and Highest and Best Use, 2nd ed. (Chicago: Appraisal Institute, 2014), Chapters 7 and 8.

Social Influences
An appraiser identifies relevant social characteristics and influences, focusing on the
demographic characteristics that tend to influence property values most in a commu-
nity. Comparing price levels in one market with prices in competing areas serves as
an indication of the overall desirability of the areas.
Although an appraiser can compile extensive demographic information, it is dif-
ficult, if not impossible, to identify the specific social preferences of the individuals
who make up a given market and to measure how these preferences affect property
value. From an appraiser’s viewpoint, the social characteristics of a neighborhood
are significant only when they are considered by the buying public and can be
objectively and accurately analyzed. Although race, religion, and national origin are
social characteristics, they have no relationship to real estate values. Appraisers must
perform unbiased analyses of neighborhoods, districts, and market areas. The Ethics
Rule of the Uniform Standards of Professional Appraisal Practice states, “An apprais-
er must not use or rely on unsupported conclusions relating to characteristics such as
race, color, religion, national origin, gender, marital status, familial status, age, receipt
of public assistance income, handicap, or an unsupported conclusion that homogene-
ity of such characteristics is necessary to maximize value.”
Economic Influences
Economic influences and government policy have a major effect on both the residential
and commercial real estate in a market area. The general decline in the US economy
in 2006 severely lessened the demand for many types of real estate, while tightened
lending requirements restricted the ability of potential home buyers and investors to
qualify for loans. Since then, the regulatory environment shows signs of loosening, but
the importance of regulations and the availability of financing cannot be overstated.
On a local level, economic considerations relate to the financial capacity of a
market area’s occupants and their ability to rent or own property, to maintain it in an
attractive and desirable condition, and to renovate or rehabilitate it when needed.
The economic characteristics that an appraiser may consider include the following:
• Mean and median household income levels
• Per capita income
• Income distribution for households
• Consumer activity
• Extent of owner occupancy
• Property rent levels and trends
• Property value levels and trends
• Vacancy rates for various types of property
• Amount of development and construction
The physical characteristics of the area and of individual properties may indicate
the relative financial strength of area occupants and how this strength is reflected in
local development and upkeep. Ownership and rental data can also provide clues
to the financial capability of residents. The income levels revealed by recent census
information, media surveys, and private studies may indicate the prices at which oc-
cupants can afford to rent or purchase property.

The presence of vacant lots or acreage suitable for development in an area may
indicate future development or a lack of demand. Current construction trends affect
the value of existing improvements. A careful study of these trends can help an ap-
praiser forecast the future desirability of an area. Block-by-block information helps
identify the direction of growth. A trend may be a local phenomenon or it may affect
the entire metropolitan area. A change in the economic base on which a community
depends (e.g., the addition or loss of a major employer) is frequently reflected in the
rate of population growth or decline.
To analyze the economic characteristics of a market area, an appraiser expands
the analysis to include economic trends over a multiyear period. Then the appraiser
decides which economic variables contribute most to value differences among loca-
tions and compares the economic characteristics of competing market areas.
Governmental Influences
As mentioned previously, government action affects the economic climate for real
estate investment. One significant legislative action on the national level was passage
of the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010. The
act was created to regulate credit cards, financial instruments, loans, and mortgages
and to increase the supervision of Wall Street investment firms, banks, hedge funds,
insurance companies, and the Federal Reserve. The ramifications of the Dodd-Frank
act are still playing out and will continue to affect the economy and real estate mar-
kets in the foreseeable future.
On the local level, governmental considerations relate to the laws, regulations,
and property taxes that affect properties in the local market and the administration
and enforcement of these constraints, such as zoning laws and building codes. The
property tax burden associated with the benefits provided in one location and the
taxes charged for similar benefits in other areas may be significantly different.
The governmental characteristics an appraiser considers in the analysis of a mar-
ket area include the following:
• Property tax burden (including special assessments) relative to services provided,
compared with other areas in the community
• Policies regarding developmental growth
• Local government development levies (impact fees)
• Zoning, building, and housing codes
• Quality of public services, such as fire and police protection, schools, and other
governmental services
Divergent tax rates or impact fees may affect market value. Local taxes may
favor or penalize certain property types. By examining the local structure of assessed
values and tax rates, an appraiser can compare the tax burdens created by various
forms of taxation and ascertain their apparent effect on the values of different types
of real estate.
Local zoning ordinances regulate land use and the density of development. With
varying degrees of success, communities regulate zoning to halt or slow growth. To
encourage new development, they may expand capital improvement programs and
construct sewage treatment facilities, fire stations, streets, and public recreational

facilities. In the absence of zoning, an appraiser should determine if any private re-
strictions are in place that would protect long-term property values.3
Zoning may also be used to enforce a community’s land use plan or comprehen-
sive plan, which is usually based on growth projections and influenced by political
considerations. Appraisers should be aware of the assumptions on which the land
use plan is based and of the potential for revision. An appraiser also must consider
the date that the plan was adopted and the plan’s projection term. The more recently
the land use plan was adopted, the more meaningful it may be.
Environmental concerns have prompted increased regulation of land develop-
ment at state and local levels. Zoning ordinances and building codes impose ad-
ditional costs on developers. To preserve environmental quality, developers are
required to consider the impact large developments will have on an area’s ecology
and on the larger environmental system. Developers may be required to improve
public roads, construct sewage treatment facilities, preserve natural terrain, or take
other actions to conform to the recommendations of local, regional, or state planning
agencies. These regulations can significantly increase the time required to complete a
development and hence increase its final cost. The value of subdivision land is influ-
enced by environmental regulations, which can affect costs and the amount of time
required to develop and sell the sites.
The creation or modification of the transportation system and the provision of
services are government actions. An improvement in the transportation system can
affect a site’s accessibility and, thus, its value. Improved transportation routes often
cause new areas to be developed. A municipality’s willingness to provide public
services to outlying areas can also affect the direction and amount of development.
Similarly, a lack of transportation routes and limitations on the expansion of sewer
service can restrict local growth.
Environmental Influences
Environmental considerations consist of any natural or man-made features that are
contained in or affect the property’s location, including the following:
• Topographical features (terrain and vegetation)
• Environmental features important to wildlife habitat
• Navigable waterways
• Open space
• Nuisances and hazards emanating from nearby facilities such as shopping centers,
factories, and schools—e.g., odors, noises, litter, vibrations, fog, smoke, and smog
• The adequacy of public utilities such as streetlights, water, sewers, and electricity
• General maintenance
• Effective ages of properties
• Changes in property use and land use patterns
• Traffic flow and traffic patterns
• Environmental liabilities—e.g., threat of landslides or flooding
3. Private restrictions on land use may be established by private owners through provisions in deeds or plat recordings. These restrictions may
specify lot and building sizes in a subdivision, permitted architectural styles, and property uses. Condominium bylaws also restrict property use.
An appraiser should make certain that private restrictions do not limit property uses inordinately.

• Access to public transportation (and type of system, e.g., bus, rail), schools (and
quality of schools), stores and service establishments, parks and recreational
facilities, houses of worship, and workplaces
A market area’s environmental characteristics cannot be judged on an absolute scale.
Instead, they must be compared with the characteristics of competing areas.
Topographical features can have positive or negative effects on property values.
The presence of a lake, river, or hill nearby can provide a scenic advantage, while
excessive traffic, odors, smoke, dust, or noise from commercial or manufacturing en-
terprises can make a neighborhood less desirable for some property types. Environ-
mental features important to wildlife habitat can cause regulators to restrict develop-
ment. For example, the presence of spotted owls, an endangered species, in forested
areas in the Northwest has led to bans on logging and development.
Gas, electricity, water, telephone, cable and internet service, and storm and
sanitary sewers are essential to meeting the accepted standard of living in most mu-
nicipal areas. A deficiency in any of these services tends to decrease property values
in a market area. The availability of utilities also affects the direction and timing of
growth or development.
Location may refer to the siting of a property and the effect of siting on accessibil-
ity—e.g., the ease of access to a corner lot compared to an interior lot. It can also refer
to the time-distance relationships, or linkages, between a property or market area
and all other possible origins and destinations of people going to or coming from
the property or market area. Usually all the properties in a well-defined market area
have the same or similar locational relationships.
City Origins and Growth Patterns

Appraisers of urban and suburban property recognize that growth and change in a community can affect
neighborhoods, districts, and other market areas differently. An appraiser must understand the factors that
contribute to urban and suburban growth patterns to analyze the market area where the subject property is
located and to determine how the area affects the quantity, quality, and durability of the subject property’s
future income or the amenities that create value.
The structure of land uses in an urban community usually reflects the settlement’s origin. This is known as
the siting factor. Some US cities were established at transportation centers such as seaports, river crossings,
or the intersection of trade routes. Other cities were founded near power sources useful to manufacturing,
and still others were located for defensive, commercial, or political reasons. As the national standard of living
improved, climate and other natural advantages became siting factors responsible for the development of
retirement areas, recreational resorts, and other specialized communities. From its initial site, a community
grows outward in a pattern dictated by the nature and availability of developable land, the evolution of tech-
nology, and the government’s ability and willingness to provide essential public services.*
Where land is scarce, communities often experience an increase in land use density. Development corri-
dors channel new construction to usable land. New technology, building materials, and construction methods
make it possible to construct high-rise buildings in cities without bedrock and those subject to earth tremors.
Transportation improvements and the proliferation of automobiles have also shaped modern cities. Im-
proved transportation allows urban settlements to expand and serve larger markets. The pattern of city growth
is influenced by the local transportation network. Growth usually radiates from the central business district
along major transportation routes. Major freeway systems can cause widespread migration from the city’s core.
* Various conceptual models of urban growth are used to describe land use patterns. These “social ecology” models include the concentric
zone theory, the sector (wedge) theory, the multiple nuclei theory, and the radial (axial) corridor theory. For a more complete discussion of
urban growth patterns, see Stephen F. Fanning, Market Analysis for Real Estate: Concepts and Applications in Valuation and Highest and
Best Use, 2nd ed. (Chicago: Appraisal Institute, 2014), Chapter 5.

When current zoning does not restrict changes from the present land use or when
a change in land use is evident, appraisers may need to examine linkages in terms of
both the current land use and the anticipated land use in the market area.
A market participant’s idea of what makes an area desirable can be studied by an-
alyzing comparable sales. The dollar and percentage differences among the sale prices
of similar properties in different locations can provide the basis for this analysis.
Characteristics of Real Estate Districts

The value influences that affect different types of districts—e.g., residential districts,
commercial districts, industrial districts—are the same as those affecting larger, more
diverse market areas, but the emphasis and relative importance of the factors change
with the type of district being analyzed.
The availability of public utilities, including sanitary sewers and municipal or
well water, is one important factor that affects land value in all districts. Prevail-
ing levels of real estate and personal property taxes also influence the desirability
of districts and may be reflected in real estate values. Of course, the four forces that
influence all real estate demand—utility, scarcity, desire, and effective purchasing
power—affect districts.
One-Unit Residential Districts

Homeownership has long symbolized economic prosperity, and the residents of an
area dominated by owner-occupied single-unit homes often take an active role in
maintaining or enhancing the value of their properties. Through formal homeowners
associations, which often enforce conditions, covenants, and restrictions in a develop-
ment, or voluntary associations such as crime watch groups and neighborhood block
clubs, property owners attempt to ensure conformity of land uses within a residential
district and thus safeguard the character, appeal, and value of neighboring homes.
Community spirit, which is evidenced in activities such as block parties and
street fairs, and activist efforts, such as lobbying against undesirable rezoning or
development, can make a residential area more stable or even reverse a trend toward
declining property values.
In built-up urban areas, single-unit homes will usually be integrated into the
complementary land uses that make up a residential neighborhood. In suburban
areas where developable land has historically been relatively cheap, single-unit
residential districts can cover large amounts of land. Recently, however, higher den-
sity projects have been developed in many areas with more common elements and
integrated or nearby conveniences such as commercial properties, schools, librar-
ies, parks, and religious facilities. In some metropolitan areas, suburban sprawl has
become as much of a social problem as flight from central cities was in the 1960s and
1970s. The influence of commuting time on the value of residential districts is signifi-
cant, whether workers are traveling to a central business district or suburban offices.
Just as the availability of labor and consumer purchasing power is essential to
the economic health of commercial and industrial districts, proximity to employment
opportunities significantly influences property values in a residential district. As em-
ployers relocate from central cities to areas closer to their employees’ homes, former
bedroom communities can develop thriving commercial districts. These districts can
rival the central business district of the larger metropolitan area and may serve as

Figure 11.3 Characteristics of One-Unit Residential Districts
Defining characteristic • Predominance of owner-occupied homes

Examples of subdistricts • Custom-built subdivisions
• Attached housing, e.g., condominiums, townhouses
• Senior housing: congregate care and living
• Rural housing
Value influences • Access to workplaces
• Transportation service
• Access to shopping centers and cultural facilities
• Proximity to an quality of schools
• Reputation of area
• Residential atmosphere and appearance
• Protection from unwanted commercial and industrial intrusion
• Proximity to open space, parks, lakes, rivers, and other natural features and to recre-
ational facilities
• Presence of vacant land likely to be developed to uses that could make the area more
or less desirable
• Private land use restrictions, e.g., covenants, conditions, and restrictions (CC&Rs)
• Public land use restrictions, e.g., zoning restrictions

an economic base for surrounding residential areas. Long-term migratory patterns
within a metropolitan area can be analyzed to forecast possible growth trends.
The topographical and climatic features of land in a residential district are gener-
ally analyzed as possible amenities or potential hazards. Access to a body of water
can increase a home’s value if the location provides a scenic view, but the same lake
or stream may reduce value if flooding occurs frequently. Sometimes a river, lake, hill,
park, or other natural feature may act as a buffer between a residential district and
commercial or industrial areas and thereby reinforce the residential area’s identity.
In recent years, the growth of the telecommuting workforce has made rural and
exurban areas far from urban and suburban employment centers into feasible resi-
dential communities by eliminating the commute. On a national level, the combina-
tion of telecommuters and self-employed individuals working at home makes up a
small percentage of the total workforce, but, according to a 2017 report, the number
of home workers increased 115% between 2005 and 2017.4 The influence of telecom-
muting on the supply of and demand for housing in a residential district can be
significant, depending on the demographics of the area. For example, the 2017 report
revealed that telecommuting currently exceeds public transportation as the preferred
commuting option in the top US metropolitan areas.
Multifamily Residential Districts

In large cities, multifamily residential districts usually cover an extensive area. In
smaller cities, such districts may be dispersed or limited in size. Units may be rented
(i.e., apartments) or privately owned as cooperatives and condominiums. Multifam-
ily districts are subject to many of the same influences that single-unit residential
areas are, but certain influences may be more important in multifamily districts
because of their higher density.
In some cities, publicly or privately published statistics on the supply of apart-
ments, vacancy rates, and rent levels are available. When published statistics are not
readily available, appraisers will have to gather data through primary research and
analyze the data appropriately.
Appraisers must be familiar with the zoning requirements for the areas in which
they are providing valuation services and be aware of building codes and require-
ments. What may be legal in a high-density, multi-unit district may not be legal in a
low density, single-unit residential district.
Commercial Districts
A commercial district is a group of offices or stores. Included in this category are
• Highway commercial districts—i.e., enterprises along a local business street or
freeway service road and developments adjacent to a traffic intersection
• Retail districts—e.g., regional, super-regional, and neighborhood shopping centers
• Downtown central business districts (CBDs)
To analyze a commercial district, an appraiser identifies its trade area—i.e., the area
the businesses serve. Because a commercial district’s economic health depends on the
4. See “Census Bureau Releases Information on Home Workers” press release and detailed tables (October 20, 2004), available at www.census.
gov/acs/www, and Brian McKenzie and Melanie Rapino, Commuting in the United States: 2009 (Washington, DC: American Community Survey
Reports, issued September 2011). See also the 2017 State of Telecommuting in the U.S. Workforce Report available at www.workflexibility.org/
state-of-telecommuting-us-2017.

Figure 11.4 Characteristics of Multifamily Residential Districts
Defining characteristic • Generally a predominance of renter occupancy and higher density than single-unit
residential districts
Examples of subdistricts • Multistory/high-rise buildings
• Garden apartments
• Row houses
• Townhouses
• Cooperative apartments
• Condominium apartments
• Master-planned communities
• Mixed-use buildings
Value influences • Access to workplaces
• Transportation service
• Access to shopping centers, cultural facilities, and entertainment
• Reputation of area
• Residential atmosphere and appearance
• Protection against unwanted commercial and industrial intrusion
• Proximity to employment
• Proximity to open space, parks, lakes, rivers, or other natural features
• Supply of vacant sites that may potentially be developed, which could make present
accommodations more or less desirable
• Parking for tenants and guests
• Vacancy and tenant turnover rate
• Proximity to public transportation
• Proximity to linkages, including arterial roads, highways, and interstates
• School districts
• Inventory levels
• Foreclosures and short sales
• Frequency of weather-related problems, such as flooding, tornadoes, and fires
vibrancy of the surrounding trade area, property values in a commercial district are
affected by the type and character of nearby land uses and other factors that influ-
ence the values of surrounding properties.
Office Districts
Office districts can contain combinations of buildings ranging from small, low-rise
structures to large, multistory buildings. The buildings in an office district may be
owner-occupied structures or serve a variety of tenants. The offices may serve multi-
national corporations, local corporations, small service companies, and professionals.

Office districts include planned office parks and strip developments on or near
major traffic arteries. Office parks, which are sometimes known as business parks or
business centers, often have industrial users among their tenants because the parks offer
good locations, easy access, attractive surroundings, and utility without the congestion
and high rents of the CBD. Office parks increasingly provide facilities for service in-
dustries as well as retailers, restaurants, computer stores, branch banks, day care cen-
ters, and other businesses. Because office parks and industrial parks rely on surround-
ing areas to supply the labor force, they are often located near residential districts and
their park-like appearance may be an advantage in the eyes of nearby residents.
Figure 11.5 Characteristics of Office Districts
Defining characteristic • Office uses with supporting retail services and other related services
Examples of subdistricts • Central business districts
• Suburban office parks
• Concentration of office properties of a particular class, as defined by the market
• Office condominiums
Value influences • Significant locational considerations such as the time-distance from potential labor
force, access, highway medians, and traffic signals
• Building configuration (floorplate size, ceiling height, etc.)
• Physical characteristics such as the visibility, attractiveness, quality of construction,
and condition of properties
• Direction of observable growth
• Character and location of existing or anticipated competition
• Availability of land for expansion
• Pedestrian or vehicular traffic count
• Vacancy and rental rates
Retail Districts
More than any other type of real estate, retail properties rely on the local trade area
for their economic base. The customers for all but the largest destination shopping
centers are drawn from the surrounding areas. The common types of retail property
can be classified by the sizes of the trade areas they serve:
• Regional shopping centers and super-regional centers can serve hundreds of
thousands of people in many communities along major transportation routes.
• Community shopping centers serve a neighborhood or group of neighborhoods
within a defined radius.

Figure 11.6 Characteristics of Retail Districts
Defining characteristics • Concentration of competing retail locations, often along a major street
• Outlots for banks, fast food restaurants, and other uses
Examples of subdistricts • Regional and super-regional shopping centers
• Community shopping centers
• Neighborhood shopping centers
• Specialty centers
• Mixed-use centers, e.g., retail and office space
• Strip retail centers
Value influences • Quantity and quality of the purchasing power of the population likely to patronize a
shopping area and any trends affecting that purchasing power (e.g., job growth)
• Significant locational considerations such as the time-distance from potential custom-
ers, access, highway medians, and traffic signals
• Physical characteristics such as the visibility, attractiveness, quality of construction,
and condition of properties
• Direction of observable growth
• Character and location of existing or anticipated competition
• Retailers’ inventory, investments, leasehold improvements, and enterprise
• Availability of land for expansion and customer parking
• Pedestrian or vehicular traffic count
• Availability of business financing, e.g., focused redevelopment plans (such as TIF
districts), minority business support, other public or private programs
• Availability of labor to work in stores and offices
• Location within a city or town or proximity to anchors and core groupings

Table 11.1 Characteristics of Shopping Centers
Neighborhood Shopping Center
Typical size 30,000 to 100,000 sq. ft.
Typical trade area • Immediate neighborhood
• Population of 3,000 to 40,000
• Radius of 3 miles
• Driving time of 5 to 10 minutes
Leading tenant Supermarket
Community Shopping Center
Typical size 100,000 to 400,000 sq. ft.
Typical trade area • Population of 40,000 to 150,000
• Radius of 3 to 6 miles
• Driving time of 10 to 20 minutes
Leading tenant Junior department store, large variety, discount, or department store
Regional Shopping Center
Typical size 300,000 to 900,000 sq. ft. (one or more department stores of around 200,000 sq. ft. each plus
small tenant space)
Typical trade area • May include several neighborhood centers
• Minimum population of 150,000
• Radius of 5 to 15 miles
• Driving time of 20 minutes
Leading tenant One or two full-line department stores
Super-Regional Center
Typical size 600,000 to 2.0 million sq. ft. or more
Typical trade area Trade areas are also extended by major transportation arteries and linkages, so the trade areas
for some super-regional centers transcend state boundaries.
• Minimum population of 300,000
• Radius of 5-25 miles
• Driving time of 30 minutes or more
Leading tenant Three or more full-line department stores
Specialty Centers
Outlet center • An aggregation of factory outlet stores
• No specific anchor tenant
Off-price center • Typically between the size of community centers and regional centers
• Specializing in name-brand merchandise sold significantly below the price at full-line department
stores
• Formerly known as discount center
Power center • Large community shopping center (more than 250,000 sq. ft.) with at least one super anchor
store (e.g., discount department store, home improvement store) with more than 100,000 sq. ft.
• Several smaller, category-specific anchor tenants (20,000 to 25,000 sq. ft.)
• Small shop space not more than 10% to 15% of total gross leasable area
• Trade area similar in size to regional shopping center
Off-price megamall • Up to 2 million sq. ft. in size
• Usually located on a major highway on the exurban fringe of a metropolitan area
• Trade area of more than 25 miles
Urban entertainment center • Combination of entertainment, dining, and retail uses in a pedestrian-oriented environment
Fashion center • Concentration of fashion retailers
• Usually no specific anchor tenant
• Wide range of trade areas, i.e., similar to neighborhood, community, or regional shopping center
depending on the target market sector as defined by quality, taste, and price
• Often higher-quality finishes and materials, lower parking ratios, higher sales per customer
Festival center • Tourist-oriented center in a large city; forerunner of urban entertainment center
• Large proportion of specialty restaurants and food vendors
Lifestyle center • National chain specialty stores plus upscale leisure amenities
• Open-air centers of 150,000 to 500,000 square feet
• Upscale projects near affluent areas
Sources: Anita Kramer, Retail Development Handbook, 4th ed. (Washington, DC: Urban Land Institute, 2008); Dollars and Cents of Shopping Centers/The Score
2008 (Urban Land Institute and International Council of Shopping Centers, 2008); James D. Vernor, Michael F. Amundson, Jeffrey A. Johnson, and Joseph S.
Rabianski, Shopping Center Appraisal and Analysis, 2nd ed. (Chicago: Appraisal Institute, 2009).

• Neighborhood and strip retail centers serve their
trade area immediate neighborhoods.
The geographic area from
which a retail property Specialty shopping centers, such as outlet malls, ware-
consistently draws most of house clubs, and power centers, serve a wide range
its customers; also called of trade areas depending on the tenant makeup and
market area. demographic and psychographic target markets.
Although an appraiser focuses on the sales poten-
tial of a given retail trade area, various other consider-
ations can complicate the analysis of value influences.
Like certain central business districts, some retail districts may contain a destination
shopping attraction. Multiplex movie theaters often anchor regional shopping centers
in urban or suburban areas and serve as destinations for consumers from a wider
trade area than a similar-sized shopping center would normally attract. On the other
hand, the growth of online shopping, to 9.3% of total retail sales in 2016, has clearly
weakened the sales potential of existing shopping centers.5 Another 1.3% of retail
sales were attributable to online purchases fulfilled at a store.
When analyzing a group of local retail enterprises that are not located in a shop-
ping center, an appraiser also examines the zoning policies that govern the supply of
competing sites, the reasons for vacancies and business failures, and the level of rents
compared with rent levels in new buildings.
Central Business Districts

A central business district (CBD) is traditionally the core, or downtown area, of a
city where the major retail, financial, governmental, professional, recreational, and
service activities of the community are concentrated. Over the past quarter of a
century, some CBDs have not experienced the same level of growth and redevelop-
ment that other commercial districts have, often because of a lack of developable land
and restrictions on redevelopment by some types of local historic preservation codes
and overlay districts. Historically, the development of suburban commercial centers
has resulted in the corresponding decline of urban CBDs. Even in smaller cities and
exurban towns, the development of commercial districts centered on a category-killer
retailer outside the town center can have a negative impact on the economic viability
of the area’s traditional business core and the value of aging properties there.
Appraisers should be aware of this trend but should also recognize that some
CBDs have brighter prospects than others, possibly as a result of economic develop-
ment efforts or a concentration of companies in strong business sectors. The eco-
nomic life cycle of CBDs is often scrutinized closely
by analysts. Transportation facilities in most cities are
central business district oriented to the CBD. Through downtown development
(CBD) associations, many merchants have made efforts to
The core, or downtown area, revitalize CBDs with improved public transportation,
of a city where the major re- larger parking areas, better access, and coordinated
tail, financial, governmental,
professional, recreational, sales promotion programs.
and service activities of the The diverse enterprises located in CBDs usually
community are concentrated. reflect several types of land use, e.g., housing, retail
stores, offices, financial institutions, and entertainment
5. PwC and Urban Land Institute, Emerging Trends in Real Estate 2018 (September 2017): 15.

facilities. Housing has not always been considered an essential land use within a
central business district, but the New Urbanism movement has long held that hous-
ing is a key driver in revitalizing or maintaining an area’s viability.6 Coffee shops and
food vendors may primarily serve office employees, and other retail establishments
tend to locate where large numbers of people work, shop, and live. Financial institu-
tions are often found in areas with other financial institutions. In major cities, enter-
tainment and cultural facilities usually operate in or near CBDs to serve the greatest
number of residents and out-of-town visitors. Different parts of the CBD attract dif-
ferent users, and the enterprises within a single general use category may be diverse.
For example, office buildings in different parts of a CBD may house a wide variety of
business and professional firms.
Figure 11.7 Characteristics of Central Business Districts
Defining characteristic • Located in a concentration of major retail, financial, governmental, professional, rec-
reational, and service activities of a city
Examples of subdistricts • Broad range of uses—office, hotel, retail, housing, and entertainment
Value influences • Local population (residents and workers)
• Transportation linkages
• Pedestrian traffic
• Municipal land use policies (e.g., density, ground coverage, parking, loading and un-
loading, signage ordinances)
• Density and mix of uses
6. Sheri Faircloth, Brian Kaiser, and Frederick A. Steinmann, “Residential Adaptive Reuse and In-fill Development,” Economic Development Journal
(Spring 2009): 40-47.

Appraisers should recognize that shifting functions within CBDs can lead to
changes in land use and potential increases in real estate values. For example, the
addition of entertainment uses to an area dominated by office uses may attract more
restaurants, art galleries, and specialty shops to a downtown area.
To assess the viability of a CBD, an appraiser must consider the sales potential
of various commercial products and services and determine whether establishments
in the CBD can attract a share of the market. To evaluate the utility of a particular
location within a CBD, an appraiser considers which use or mix of uses—e.g., office,
hotel, retail, housing, entertainment—is most appropriate.
Entertainment Districts
Entertainment districts are a special type of mixed-use development that typically
relies on one or more live entertainment venues, such as a sporting facility, to anchor
a variety of entertainment, leisure, and related land uses. These districts tend to be
unique, often incorporating a theme or reflecting specific characteristics of the local
area. Entertainment districts are typically large-scale developments that often, but
not always, involve multiple ownerships and may include the public sector. They
can be found in both urban and suburban locations. In either location, they tend to be
relatively high-density developments that emphasize walkability.
While there is no formula or fixed mix of uses, these districts tend to include a mix
of live entertainment venues, such as sports arenas, ballparks, or stadiums, combined
with live theater and performing arts venues, concert halls, and small venues suitable for
live entertainment and recorded entertainment (e.g., movie theaters). Bars, restaurants,
cafes, and other food-related uses are an important element. Entertainment districts typi-
cally offer a wide variety of price points and styles, from casual and relaxed restaurants
to formal fine dining. Other ground floor uses may include art galleries and retail shops.
Upper floors are often devoted to hotel, office, and multi-unit residential uses.
The nature of public sector involvement in entertainment districts varies in both
scope and magnitude. In some cases, the streetscape improvements are used to create
an identity for the area. Public agencies may also participate by providing parking or
other forms of direct investment.
Industrial Districts
Industry is often the engine of economic growth in a community. Governmental and
public-private economic development efforts are often targeted at manufacturing and
other industrial concerns that may bring high-paying jobs to an area. Since the 1980s,
major manufacturers have sought to control inventory costs by implementing just-
in-time production (also known as lean manufacturing) techniques, and the suppliers
who serve those companies have tended to cluster around their headquarters.
Industrial districts range from those that contain heavy industry, such as
steel plants, foundries, and chemical companies, to those that contain assembly,
distribution, and other “clean” operations. In most urban areas, heavy industry
and light industry districts are established by zoning ordinances, which may limit
uses and place controls on air pollution, noise levels, and outdoor operations. Most
manufacturing districts and industrial parks consist of one-story buildings with
greater ceiling heights than were typical previously. Each industrial district has a
value pattern that reflects the market’s reaction to its location and the characteristics
of its sites and improvements.

Figure 11.8 Characteristics of Industrial Districts
Defining characteristic • Cluster of related industrial concerns, e.g., a manufacturer and its suppliers
Examples of subdistricts • Manufacturing facilities
• Research and development facilities/science parks
• Warehouse/distribution facilities
Value influences • Nature of the district (distribution, manufacturing, R&D, etc.)
• Availability of labor and competitiveness of labor pool with offshore sites
• Transportation facilities
• Availability of raw materials
• Distribution facilities
• Political climate
• Availability of utilities and energy
• Effect of environmental controls
• Governmental land use restrictions or lack of such restrictions
Many small towns, suburbs, and rural areas may have only one industrial park
that contains a variety of industrial buildings, which may provide employment for a
substantial part of the population. Often support services such as copy centers, deliv-
ery services, stores, restaurants, print shops, fitness centers, and day care centers can
be found in modern industrial parks.
The environmental liabilities incurred by heavy industry are considerably more
complex than those that affect other property types. Industrial properties may con-

tain underground or aboveground storage tanks or silos for a broad range of chemi-
cals, and the presence of asbestos and PCBs may be widespread. Long-term contami-
nation tends to be more severe in industrial districts than in commercial and residen-
tial districts, and cleanup costs can be high. (Environmental liabilities are discussed
more fully in Chapter 12.)
Agricultural Districts
Agricultural districts can be as small as a portion of a township or as large as several
counties. Most important value influences relate to individual properties rather than
to entire agricultural districts because the individual properties may be far apart.
Nevertheless, an agricultural district’s physical features are usually representative of
the individual farms within it and contribute to their desirability.
Figure 11.9 Characteristics of Agricultural Districts
Defining characteristic • Undeveloped land use for production of crops, timber, livestock, and other agricultural
products
Examples of subdistricts • Row crops
• Orchards, groves, and nurseries
• Grasslands
• Livestock facilities
• Dairies
• Agribusiness
• Timberland and sod farms
• Natural resource land, e.g., mining facilities
Value influences • Climate
• Location
• Topography
• Soil types
• Water rights
• Conforming land uses in the market area
• Size of agricultural operation
• Transportation
• Availability of farm labor, which is often captured in the analysis of conforming land uses
• Conservation easements

The importance of different value influences in an agricultural district depends
on what is produced there. Agricultural production areas are served by thorough-
fares that lead to marketing centers where farm products are sold, and proximity
to other forms of transportation such as rivers and railroad lines can be even more
important in some areas. Like an urban neighborhood, the farm community depends
on government services such as roads and schools and on the availability of power
sources (e.g., electricity, natural gas).
Infrastructure to support the particular land use dominant in a district is im-
portant in all districts, but it is particularly important in agricultural districts. The
infrastructure for agriculture includes land uses such as
• Equipment sales and repair
• Livestock auctions
• Outlets for seed, feed, fertilizer, herbicides, and similar products
• Processors or intermediaries to buy, sell, or transport farm products
• Government offices—e.g., Farm Service Agency, Soil Conservation Service
• Colleges and universities with agricultural studies programs
For many years, urban encroachment into agricultural districts and the erosion of
the agricultural infrastructure have been concerns of property owners in rural areas
because urban land uses generally do not complement agricultural uses. Governmen-
tal attempts to preserve agricultural land have had limited effectiveness because the
causes of encroachment are so complex.
Environmental liabilities on agricultural properties may include dump sites,
cattle vats, waste lagoons for confined feeding operations, fertilizers, pesticides, and
underground storage tanks.
Specialty Districts
Individual properties are sometimes appropriate only for an existing special-purpose
use. Similarly, if some specialized land use is predominant in a market area, that area
may qualify as a specialty district, such as the following:
• Medical district
• Research and development park
• Technology park
• Life science and biotechnology parks
• Education district
• Historic district
The value influences at work in these specialty districts may be similar to those af-
fecting areas where traditional land uses dominate (in particular, office districts), but
the emphasis may change depending on the activity that characterizes the specialty
district. Also, most specialty districts have specific land use approval from local gov-
ernments, either by a zoning designation or an overlay.
Medical Districts
A medical district typically is centered around one or more regional acute care hos-
pitals that have spawned a heavy concentration of allied healthcare uses, potentially
including other specialty hospitals, ambulatory surgical centers, clinics, long-term

Table 11.2 Characteristics of Specialty Districts
Type Characteristics/Value Influences
Medical district • Potential for functional obsolescence of improvements
• Proximity to hospitals and other medical offices
• Quality of professional personnel
• Availability of modern equipment
• Demographics (i.e., proximity to residential districts with many seniors who are
the primary consumers of medical services)
• Linkages (e.g., public transportation)
• Reliability of power sources/backup power systems
• Waste disposal, particularly infectious materials
Research and development park • Mix of office, laboratory, and industrial uses
• Closely tied to nearby research universities, which may also provide parking
• University provides ongoing supply of intellectual talent and qualified workers
High-technology park • Clustered around high-tech companies and near fiber optic cable corridors and
highly skilled labor and universities
• Sometimes receive favorable financing packages from local government and
economic development corporations
• Typically focused on later-stage development and marketing of new technologies
• Benefit from proximity to educated workforce
Education district • May contribute economically as well as socially and culturally to the surrounding
community
• Should be accessible to surrounding residential neighborhoods if student hous-
ing is needed
• Access to public transportation important for institutions that appeal to commuters
Historic district • May include residential, commercial, industrial, or other types of property alone
or in combination with one another
• Designated by federal, state, or local governments to preserve an area’s archi-
tectural character
• Federally certified only after stringent requirements have been met, including
substantial compliance with the criteria of the National Register of Historic Places
• Private preservation restrictions, such as preservation easements and historic
facade easements, can limit future uses within the district
• Level of protection varies, but highest and best use and possible redevelopment
may be restricted by specific zoning or historic overlay provisions
care facilities, medical offices, educational facilities, and substantial parking facilities
to support these high-use structures in a campus setting. The creation of synergies
through the concentration of physicians and other medical specialists is a chief rea-
son why medical districts have evolved.
Medical districts can be found in densely populated urban areas and in spacious,
park-like settings, although the general trend of suburbanization may be causing
medical uses to spread out. Close proximity to regional highways is critical for fast
access in emergencies and for many of the same reasons regional shopping and office
districts desire these locations. In urban and mature suburban medical districts, and
where there is a very strong hospital operation, demand for land may be extraordi-
nary, and nonmedical use may no longer represent the highest and best use of prop-
erties improved for nonmedical use.

The financial health and condition of the physical plant of the hospital driving the
demand for other medical land uses in the district are important to assess. Hospitals
that are expanding create further demand on land in their vicinity. Should the hospital
build a replacement facility elsewhere in the community, or simply cease operation, de-
mand for the surrounding health care-related properties will be affected. To assess these
risks, an appraiser can examine a hospital’s financial condition using various public
sources, including state health departments and hospital associations, and commercial
sources such as the American Hospital Directory online service. In many states, hospital
and other medical facilities (nursing facilities, ambulatory surgical centers) are required
to have a certificate of need (CON) or determination of need (DON) prior to construc-
tion or acquisition of major medical equipment. As these state agencies often use analyt-
ics for long-range planning, they may offer insights into the future of a hospital district.
The desirability and value of medical properties are generally influenced by the
same forces as other commercial and residential real estate, but there are unique fac-
tors affecting health care property values. Population changes, general economic and
employment conditions, and political factors warrant examination. A large portion of
the nation’s health care expense is covered through the federal Medicare and federal
and state Medicaid programs. Many other expenses are covered through employer-
sponsored medical insurance. Sudden changes in these programs can have a signifi-
cant impact on the viability of health care providers. Medicare is a social equalizer in
some respects, as the payments to a hospital, physician, or other provider will be the
same for that service within a given region regardless of the value of the property in
which the service was performed. Also, many states regulate the supply of hospitals,
nursing facilities, and ambulatory surgical centers.
Demographic factors are important. Seniors consume more health care services
than other demographic groups, and many elderly Americans have adequate health
insurance through Medicare or commercial alternatives. Low-paying Medicaid and
uninsured populations are closely tied to low-income households, and areas with
large concentrations of these households often have fewer medical services. The
services that are available tend to be housed in older, less functional buildings. The
quality of professional personnel and the availability of modern equipment are also
important considerations.
Utilities are a particular concern in medical districts because power outages can
have disastrous effects on hospitals. To increase reliability, most hospitals augment
the electrical service available from the power grid with backup systems. The dispos-
al of medical waste and potentially infectious materials has become highly controver-
sial. Many hospitals incinerate their waste, while others have it shipped offshore.
Research and Development Parks

Characterized by a mix of office and industrial uses, research and development (R&D)
parks, also known as science parks, may contain the research and development depart-
ments of large drug, chemical, or computer companies, or they may cater to firms
specializing in research activities. Research firms are usually small and specialize in
identifying and developing new products, which are sold to other firms. Occasionally
a small research firm will create, develop, and market a new product with consider-
able success, but then the nature of the firm must shift from research to marketing.
Research and development parks are often located near one or more research
universities and, in some cases, may be sponsored and promoted by universities.

This proximity provides a convenient source of technical expertise and qualified em-
ployees. Universities may sponsor a park to sell excess land, provide employment for
students and faculty, and raise an area’s level of economic activity.
Buildings in research and development parks have evolved from one-story, on-
grade warehouses with a comparatively high percentage of office build-out (i.e., 20%-
35% office space) built in the 1970s and 1980s to multistory office (lab) buildings with
a loading dock. These buildings now look more like office buildings than industrial
buildings. The interior build-out often includes a mix of traditional office space, labo-
ratory/workshop space, and some unfinished warehouse space. The precise build-
out varies with the user and it can be difficult to determine the build-out from the
exterior alone. Some facilities may contain highly specialized build-outs that include
clean rooms, fabrication facilities, and specialized manufacturing improvements.
Required parking ratios depend on the level of occupancy and are often determined
by the level of build-out of the various space types.
High-Technology Parks
Firms engaged in high-tech activities often locate near one another or in parks where
technical expertise may be available from a nearby university or research facility.
Electronics and computer firms initially dominated technology parks and remain a
mainstay of modern technology parks. However, today’s high-tech parks are now
likely to include a wide range of technology firms related to aerospace, defense,
pharmaceuticals, and life sciences as well as data centers and robotics and software
developers. While similar in many respects to research parks, high-tech parks tend
to attract firms that are less research-oriented and more focused on product develop-
ment and marketing a technological solution. R&D and high-tech parks share many
of the same characteristics and have become indistinguishable in many cases. They
often share a campus-like style with low-rise, low-density, stand-alone buildings sur-
rounded by surface parking and well-landscaped grounds.
Recent development trends show the incorporation of outdoor amenity space in
high-tech parks, including recreation areas with fire pits, sports courts, and similar
site improvements, which encourage social and collaborative interaction among em-
ployees. To incorporate natural elements in the built environment—a concept known
as biophilia—some park structures include plants, natural light, and views of nature
to encourage psychological well-being and productivity. Wellness-based design
elements that support the physical and psychological needs of employees are also
increasingly being incorporated into high-tech office and R&D environments.
Sometimes local governments and economic development corporations will
create designated technology corridors to attract high-tech companies. Real estate
developments in technology incubator areas may benefit from favorable financing
packages and receive subsidies or tax breaks.
Life Science and Biotechnology Parks

Life science and biotechnology parks combine aspects of both R&D and high-tech
parks. Occupants in these parks are firms focused on developing drug therapies to
address human illnesses. These facilities typically include wet lab space for chemistry
and biological research, combined with conventional office space. Due to the physical
and mechanical requirements of wet labs regarding ventilation, air purification, and

plumbing, the facilities typically require above-standard slab-to-slab floor heights to
accommodate the mechanical equipment. Build-outs typically include intense plumb-
ing and process lines for various gases and liquids. Some life science facilities include
specialized improvements such as pilot plants that serve as protypes for larger manu-
facturing facilities or vivariums that maintain animals for drug testing purposes. Life
science facilities are often less densely occupied by humans than other types of office
and R&D facilities, and thus parking ratios may be lower.
Education Districts
Local schools, colleges, and universities may constitute a district if they have several
buildings or facilities and are considered an integral part of the surrounding resi-
dential neighborhood. Education districts may contribute economically as well as
socially and culturally to the surrounding community.
Colleges and universities often attract students from far away who bring in-
come to the community and thus contribute to its economic base. In some towns and
smaller cities, universities and colleges may provide most of the economic base.
Important land use linkages for education districts include
• Access to the surrounding residential neighborhood, particularly high-density
housing like apartments or single-family housing with zoning that allows mul-
tiple students per house
• Access to nearby convenience shopping such as grocery stores, drug stores, and
fast food restaurants
• Access to public transportation for educational institutions that appeal to commuters
Historic Districts
Since 1931, when the first historic district zoning ordinance was passed in the United
States, interest in preserving historically and architecturally significant properties has
grown and given rise to a unique type of district.7 There are more than 11,900 historic
districts listed in the National Register of Historic Places. In addition, there are more
than 2,300 locally enacted historic preservation ordinances in the United States, many (if
not most) of which provide some form of protection to locally designated historic dis-
tricts. Some local historic districts are actual zoning districts, while others are historic or
conservation overlay districts that preserve an area’s architectural or historic character.
Locally designated historic districts are federally certified only after stringent
requirements have been met, including substantial compliance with the criteria of the
National Register of Historic Places.8 Once a district has been added to the National
Register or a local district has been federally certified, developers, investors, and
renovation specialists can qualify for tax incentives such as the tax credits allowed
under the Economic Recovery Tax Act of 1981 (which were subsequently reduced by
the Tax Reform Act of 1986). Many states and even local tax assessment jurisdictions
also provide incentives such as tax credits or property tax assessment relief to owners
of contributing historic properties in designated historic districts.
7. Russell V. Keune, ed., The Historic Preservation Yearbook (Bethesda, MD: Adler & Adler, 1984), 461. See also Judith Reynolds, Historic Properties:
Preservation and the Valuation Process, 3rd ed. (Chicago: Appraisal Institute, 2006); Paul K. Asabere and Forrest E. Huffman, “Historic Designation
and Residential Market Value,” The Appraisal Journal (July 1994): 396–410; Patrick Haughey and Victoria Basolo, “The Effect of Dual Local and
National Register Historic District Designations on Single-Family Housing Prices in New Orleans,” The Appraisal Journal (July 2000): 283-289;
Emma Brandt Vignalli, “Preserving the Old with the Compatible New,” 59 Wm. & Mary L. Review 345 (2017), and Richard J. Roddewig and Charles
T. Brigden, Appraising Conservation and Historic Preservation Easements, 2nd ed. (Chicago: Appraisal Institute, 2020).
8. Keune, 328.

Historic districts may include residential, commercial, industrial, or other types
of property alone or in combination with one another. While listing in the National
Register by itself provides only limited protections to historic districts, many local
historic preservation ordinances require prior review of proposed alterations and de-
molitions in historic districts. Appraisers of historic property must become thorough-
ly familiar with the criteria applicable to each district’s designation status, the types
of reviewable actions and review criteria, and how these criteria or available tax
incentives are, or may be, applied to properties within district boundaries. Privately
imposed historic restrictions such as preservation easements and historic façade ease-
ments can limit the future uses of a property and thereby influence value in a manner
different from the impact of the federal, state, or local government designation of a
historic district.

Land and Site Description 12
Appraisal assignments may be undertaken to develop an opinion of the value of land

only or the value of both land and improvements. In either case an appraiser must
provide a description and analysis of the land. Land can be raw or improved. Land
may be located in rural, suburban, or urban areas and may have the potential to be
developed for residential, commercial, industrial, agricultural, or special-purpose use.
This chapter focuses on the description and analysis of the land component of real
property. Because appraisers typically deal with land that has been improved to some
degree, the term site is often more precise than land, and site is used predominantly in
this chapter. The information needed to complete a full site description and analysis is
noted and explained here, and sources of this information are presented. Although this
discussion relates primarily to the property being appraised, the same type of data is
collected and examined in analyzing the comparable properties used in the appraisal.
A parcel of land can have various site improvements that enable the vacant
parcel to support a specific purpose. A site can have both on-site and off-site im-
provements that make it suitable for its intended use or development. Off-site
improvements may include utility lines, access to roads, and water, drainage, and
sewer systems. On-site improvements may include landscaping, site grading, access
driveways, drainage improvements, accessory build-
ings, and support facilities.
In valuing any type of property, an appraiser must raw land
describe and analyze the site. Site description consists Land that is undeveloped;
of comprehensive factual data, information on land use land in its natural state
restrictions, a legal description, other title and record before grading, draining,
subdivision, or the installa-
data, and information on pertinent physical character- tion of utilities.
istics. Site analysis goes further. It is a careful study of site
factual data in relation to the market area characteris- Land that is improved so
tics that create, enhance, or detract from the utility and that it is ready to be used for
marketability of specific land or a given site as com- a specific purpose.
pared with other sites that it competes with.
One primary objective of site analysis is to gather data that will indicate the high-
est and best use of the site as though vacant so that land value for a specific use can
be estimated. (See Chapters 17 and 18 for a complete discussion of highest and best
use.) Whether a site or raw land is being valued, an appraiser must determine and
evaluate its highest and best use. When the highest and best use of land is for agri-
culture, the appraiser usually analyzes and values the land using sales comparison. If
the land is to be developed for urban use, the appraiser may use a more sophisticated
technique such as subdivision development analysis.
Legal Descriptions of Land

Land boundaries differentiate separate ownerships, and the land within one set of
boundaries may be referred to as a parcel, lot, plot, or tract. These terms may be ap-
plied to all types of improved and unimproved land, and they are often used inter-
changeably by market participants. An appraiser, however, should use the terms
consistently in the appraisal report to avoid confusing the client.
A parcel of land generally refers to a piece of land that can be identified by a com-
mon description and is held in one ownership. Every parcel of real estate is unique.
To identify individual parcels, appraisers rely on legal descriptions, surveys, or other
descriptive information typically provided by the client or found in public records. A
legal description identifies a property in such a way that it cannot be confused with
any other property. A legal description, though not required, is usually included or
referenced in an appraisal report.
In the United States, three methods are commonly used in legal descriptions of
real property:
• The metes and bounds system
• The rectangular survey system
• The lot and block system
An appraiser should be familiar with these forms of legal description and know
which form or forms are common in the area where the appraisal is being conducted.
Metes and Bounds

The oldest known method of surveying land is the metes and bounds system, in
which land is measured and identified by describing its boundaries. A metes and
bounds description of a parcel of real property describes the property’s boundaries in
terms of precise reference points. A metes and bounds description starts at the point
of beginning (POB), a primary survey reference point that is tied to a benchmark or
adjoining surveys, and moves along past several intermediate reference points before
finally returning to the POB. The return to the POB is called closing and is necessary
to ensure the survey’s accuracy.
Surveyors in the field increasingly rely on modern “total stations” to collect data
in digital form. The familiar surveyor’s measuring instrument mounted on a tripod
uses infrared technology and today is augmented by portable computer technology.
The data is downloaded into the surveyor’s office computer for plotting the property
boundaries and computing the land area. Coordinate geometry software and global
positioning system (GPS) technology allow for more accurate determinations of
directions, distances, and areas. GPS technology is only limited by physical obstruc-

Figure 12.1 Metes and Bounds System
North Line of Section 12
Northwest Corner of Section 12

140'
POB
260'
100'
West Line of Section 12
20 30'
S
45
0'
º
E
400'
tions that prohibit receiving satellite transmissions, and its use in surveying will
probably increase.
The metes and bounds system is the primary method for describing real property
in 21 states. It is often used in other states as a corollary to the rectangular survey
system, especially in describing unusual or odd-shaped parcels of land.
Rectangular Survey System

The rectangular survey system, which is also known as the government survey system,
was established by the Land Ordinance of May 20, 1785. The rectangular survey sys-
tem became the principal method of land description for most land north of the Ohio
River or west of the Mississippi River.
The initial reference points for government surveys were established in the late
eighteenth century. From each point specified, true east-west and north-south lines
were drawn. The east-west lines are called base lines and the north-south lines are
called principal meridians. In this system, each parcel of land is identified in terms of
its relationship to a single base line and a single principal meridian.
Lot and Block System

The lot and block system was developed as an outgrowth of the rectangular survey sys-
tem and can be used to simplify the locational descriptions of small parcels. The system
was established when developers subdivided land in the rectangular survey system and
assigned lot numbers to individual sites within blocks. The maps of these subdivisions
were then filed with the local government to establish a public record of their locations.
Each block was identified precisely using a ground survey or established monuments.

Figure 12.2 Rectangular Survey System
Township Tier Township
Principal Meridian Township Lines 36 Sections
N N 6 miles
6 5 4 3 2 1
7 8 9 10 11 12
18 17 16 15 14 13
West East
T 2N R 3E 19 20 21 22 23 24
30 29 28 27 26 25
Base Line 31 32 33 34 35 36
Range Lines South
Figure 12.3 Lot and Block System

3rd Avenue
1 2 3 4 5 6 1 2 3 4 4 5 6
2
12 11 10 9 8 7 1 2 3 5 4 5 6
Oak Street
6 5 4 3 2 1 1 2 3 4 5 6
3 6
7 8 9 10 11 12 11 10 9 8 7
Applying the lot and block system to old, unsurveyed communities helped to
identify each owner’s site or parcel of land. Typically a surveyor located the boundar-
ies of streets on the ground and drew maps outlining the blocks. Then lot lines were
established by agreement among property owners. A precise, measured description
was established for each lot and each was given a number or letter that could be re-
ferred to in routine transactions. This information was recorded in public records and
was known as a recorded plat of the defined area or subdivision. All this information is
necessary to support the legal ownership of real property and its sale and financing.

Title and Record Data
Before making an on-site inspection, an appraiser should obtain an appropriate legal
description and other property data from the client or from published sources and
public documents. Most jurisdictions have a public office or depository for deeds
where transactions are documented and made public. The accessibility of public re-
cords, which is legally known as constructive notice, ensures that interested individu-
als are able to research and, if necessary, contest deed transfers.
Sometimes public records do not contain all relevant information about a par-
ticular property. Although official documents are dependable sources of information,
they may be incomplete or not suited to an appraiser’s purposes. Useful support data
can be found in land registration systems, land data banks, and assessors’ maps.
Where to Find
Title and Record Data

Most county recorders’ offices keep index books for land deeds and land mortgages from which the book
and page number of a recorded deed may be found. In addition, official municipal plat books may be exam-
ined in the auditor’s office. Much of this data is now available online.
Ownership Information
If a partial interest in a property is to be appraised rather than the fee simple interest,
the elements of title that are to be excluded should be indicated and carefully ana-
lyzed. An appraiser who is asked to develop an opinion of the value of a fractional
ownership interest must understand the exact type of legal ownership to define the
property rights to be appraised.
After defining the property rights being appraised, appraisers must identify any
excluded rights that may affect value. Appraisers should also investigate the owner-
ship of surface and subsurface rights through a title report, an abstract of title, or
other documentary evidence of the property rights to be appraised. Title data indi-
cates easements and restrictions, which may limit the use of the property, as well as
special rights such as air rights, water rights, mineral rights, obligations for lateral
support, and easements for common walls. Appraisers are typically not experts in
title information but must rely on legal opinions, title research reports, and title data
provided by other professionals. Easements, rights of way, and private and public
restrictions often affect property value.
Easements may provide for overhead and underground electrical transmission
lines, underground sewers or tunnels, flowage, aviation routes, roads, walkways,
and open space. Some easements or rights of way acquired by utility companies or
public agencies may not have been used for many years, and an appraiser’s physi-
cal inspection of the property may not disclose any evidence of such use. In certain
jurisdictions, easements that are not used for a finite period of time may be automati-
cally terminated. Use of a property for access without the owner’s written permission
may give the user a prescriptive easement across the property. This type of easement
usually must be used for several years without being contested or challenged by the
property owner. Title insurance companies often overlook this easement unless it has

been perfected in court. Nevertheless, appraisers should search diligently for infor-
mation pertaining to any limitations on ownership rights.
Private restrictions may have a material impact upon the value of property. Restric-
tions cited in the deed may limit the type of building or business that may be conduct-
ed on the property. A typical example is a restriction that prohibits the sale of alcohol
or gasoline in a certain place. Others may limit further subdivision of a tract while
others may proscribe certain uses (e.g., commercial or multifamily). Appraisers may
occasionally encounter unusual restrictions driven by the eccentricities of prior owners.
Restrictions can apply for a specified number of years and generally run with the land.
Appraisers should carefully consider the value impact, if any, of such restrictions.
Where to Find
Ownership Information
A property’s legal owner and type of ownership can be found in the public records maintained by the local
clerk and recorder. Local title or abstract companies may also provide useful information.
Zoning and Land Use Information

Land use and development are usually regulated by city or county government, but
they are often subject to regional, state, and federal controls as well. In analyzing zon-
ing and building codes, an appraiser considers all current regulations and the likeli-
hood of a change in the code. Usually a zone calls for a general use (such as residen-
tial, commercial, or industrial) and then specifies a type or density of use. Zoning and
other land use regulations often control the following:
• Height and size of buildings
• Lot coverage or floor area ratio (FAR)
• Required landscaping or open space
• Number of units allowed
• Parking requirements
• Sign requirements or limitations
• Building setbacks
• Plan lines for future street widenings
• Other factors of importance to the highest and best use of the site
Most zoning ordinances identify and define the uses to which a property may
be put without reservation or recourse to legal intervention. This is referred to as a
use by right. They also describe the process for obtaining nonconforming use permits,
variances, and zoning changes, if permitted. In areas subject to floods, earthquakes,
and other natural hazards, special zoning and building regulations may impose
restrictions on construction. Zoning, planning, and land use restrictions may govern
building location and design in coastal and historic districts.
Although the term legally nonconforming land use is often used to describe prop-
erties that do not conform to zoning and building codes, the term should only be

applied to properties that do not conform to allowable land uses. Some properties
include improvements that conform to land use regulations but do not meet building
or developmental standards. For example, consider a property with a 30-foot setback
in an area where the new zoning code specifies a minimum 40-foot setback. The land
use is conforming, but the property does not conform to development standards.
This is an important distinction because some lenders have rules about legally non-
conforming uses.
Potential changes in government regulations must also be considered. If, for
example, a building moratorium or cessation of land use applications is in effect for a
stated period, a property’s prospective highest and best use may have to be delayed.
The appropriateness of the current zoning and the reasonable probability of a zoning
change must be considered. Highest and best use recommendations may rely on the
probability of a zoning change. One of the criteria for the highest and best use con-
clusion is that the use must be legally permissible. If the highest and best use of a site
is predicated on a zoning change, an appraiser must investigate the probability that
such a change will occur. The appraiser may interview planning and zoning staff and
study patterns of zoning change to assess the likelihood of a change. After reviewing
available public and private land use information, the appraiser may also prepare a
forecast of land development for the area. If the zoning of the subject site is not com-
patible with the probable forecast uses, the probability of a change in the zoning is
especially high. Appraisers should recognize, however, that a zoning change is rarely
100% certain and should alert the client to that fact if it is relevant to the purpose of
the appraisal.
Where to Find
Zoning and Land Use Information

Although zoning ordinances and maps are public records that are available at zoning offices and online, an
appraiser may need help from planning and zoning staff to understand the impact of zoning regulations.
Often an appraiser must contact several agencies. Zoning and land use restrictions are not usually listed in
the recorded title to a property, so confirmation from controlling agencies is necessary.
Assessment and Tax Information

Real property taxes in all jurisdictions are based on ad valorem assessments, at least
in part. (Many areas have parcel taxes as well, which are not a function of assessed
value.) Taxation levels are significant in considering a property’s potential uses. From
the present assessment, the current tax rate, and a review of previous tax rates, an ap-
praiser can form a conclusion about future trends in property taxation. Assessed val-
ues may not be good indicators of the market value of individual properties because
mass appraisals based on statistical methodology tend to equalize the application of
taxes to achieve parity among assessment levels in a given district. Nevertheless, in
some areas and for some property types, assessed value may approximate market
value. The reliability of local assessments as indicators of market value varies from
district to district.

Where to Find
Assessment and Tax Information

The records of the local assessor or tax collector can provide details concerning a property’s assessed value
and annual tax burden. Often, an appraiser obtains property information from the local assessor before
conducting a physical inspection of the property.
Physical Characteristics of Land

In site description and analysis, an appraiser describes and interprets how the physical
characteristics of the site influence value and how the physical improvements relate to
the site and to neighboring properties. Important physical characteristics include
• Site size and shape
• Corner influence
• Plottage potential
• Excess land and surplus land
• Topography
• Utilities
• Site improvements
• Accessibility
• Environment
Size and Shape

A size and shape analysis describes a site’s dimensions (street frontage, width, and
depth) and lists any advantages or disadvantages caused by these physical charac-
teristics. An appraiser describes the site and analyzes how its size and shape affect
property value. Special attention is given to any characteristics that are unusual for
the neighborhood. The effects of the size and shape of a property vary with its prob-
able use. For example, an odd-shaped parcel may be appropriate for a dwelling but
unacceptable for certain types of commercial or industrial use. A triangular lot may
not have the same utility as a rectangular lot due to its size and shape.
The size of a parcel of land is measured and expressed in different units, depending
on local custom and land use. Large tracts of land are usually measured in acres. Smaller
parcels are usually measured in square feet, although acreage may also be used. Dimen-
sions are expressed in feet and tenths of feet, rather than inches, for easy calculation.
Frontage is the measured footage of a site that abuts a street, lake or river, rail-
road, or other feature recognized by the market. The frontage may or may not be the
same as the width of the property because a property may be irregularly shaped or
have frontage on more than one side.
Size differences can affect value and are considered in site analysis. Reducing sale
prices to consistent units of comparison facilitates the analysis of comparable sites
and can help identify trends in market behavior. Generally, as size increases, unit
prices decrease. Conversely, as size decreases, unit prices increase. The functional
utility or desirability of a site often varies depending on the types of uses to be placed
on the parcel. Different prospective uses have ideal size and depth characteristics

that influence value and highest and best use. An appraiser should recognize this fact
when appraising sites of unusual size or shape. Value tendencies can be observed by
studying market sales of lots of various sizes and their ability to support specific uses
or intensities of development. In residential appraisal, a large triangular lot may not
have any greater value because only one dwelling unit can be built on it according
to zoning and subdivision regulations. The large undeveloped remainder would be
surplus land, which is discussed below.
Corner Influence
Properties with frontage on two or more streets may have a higher or lower unit
value than neighboring properties with frontage on only one street. The advantage of
easier access to corner sites may be diminished by a loss of privacy or a loss of utility
due to setback requirements. An appraiser must determine whether the local market
considers a corner location to be favorable or unfavorable. This determination can
change depending on the use (or uses) anticipated for the site.
In the layout of building improvements and the subdivision of large plots, corner
lots have more flexibility and higher visibility than interior properties. A store on
a corner may have the advantage of direct access from both streets and prominent
corner visibility and exposure. Corner exposure may provide advantageous ingress
and egress for a drive-in business. As examples, the best corner sites for gas sta-
tions, branch bank buildings, and drug stores are near the intersections of major
thoroughfares with good exposure to traffic in all directions where the intersection is
controlled by traffic lights in all directions. Secondary corner locations can be less de-
sirable for those commercial uses because of the lack of traffic lights or access limita-
tions such as right-in, right-out entrance configurations. The intersections of two local
roads or a local road and a highway may not enjoy the competitive advantage that a
corner lot at the intersection of more heavily trafficked thoroughfares would.
For residential properties, corner locations may have negative implications. Qui-
et, cul-de-sac sites in the interior of a subdivision may be more desirable and com-
mand higher prices. Residences on corner sites are exposed to more traffic noise and
provide less security. Owners of corner sites may pay higher costs for front-footage
sidewalks and assessments, and the side street setback may affect the permitted size
of the building. Usually owners of residences on corner lots have to maintain a larger
landscaped area which may, in fact, be public property.
Plottage Potential
Plottage is an increment of value that results when two or more sites are combined
to produce a larger site with greater utility and probably a different highest and
best use. When the unit value of two or more parcels is greater if they are combined
than if they are separate, plottage value is created. For example, there may be great
demand for one-acre lots in an industrial park where most of the platted lots are
of one-half acre. By itself, a half-acre lot has a value of $1.00 per square foot. When
combined with an adjacent half-acre lot, however, the value may increase to $1.50
per square foot. The value difference may be offset by the premium a developer
often has to pay to combine adjacent properties. Sometimes the reverse may occur
if the lots are very large and assemblage yields a lower value per square foot in the
marketplace due to negative economies of scale. Plottage value may also apply to an

existing site of a special size or shape that has greater utility than more conventional,
smaller lots.
Plottage is significant in appraising agricultural land. Properties of less-than-
optimum size have lower unit values because they cannot support the modern equip-
ment needed to produce maximum profits. In an urban area, plottage of commercial
office and retail sites and of residential apartment sites may increase the unit values
of the lots assembled.
Although the assemblage of land into a size that permits a higher and better use
may increase the land’s unit value (dollars per square foot or acre), the reverse may
also occur. Land that must be divided or subdivided to achieve a higher and better
use is commonly sold in bulk at a price less than the sum of the retail prices of its
components. The lower unit price for the bulk sale reflects market allowances for
risk, time, management, development costs, sales costs, profit, and other consider-
ations associated with dividing and marketing the land.
Excess Land and Surplus Land

A given land use has an optimum parcel size, configuration, and land-to-building ratio.
Any extra or remaining land not needed to support the specific use may have a different
value than the land area needed to support that use. The portion of the property that
represents an optimal site for the existing improvements will reflect a typical land-to-
building ratio. Land area needed to support the existing use or ideal improvement can
be identified and quantified. Any remaining land area is either excess or surplus land.
As an example, consider a residential property that consists of one single-unit
home and two standard-size lots in a fully developed subdivision. If the house is
situated within the boundaries of a single lot and the normal land area for properties
in the neighborhood is a single lot, then the second, vacant lot would most likely be
considered excess land. This excess land could be separated from the lot of the exist-
ing structure and the separated parcel could be developed with a new home. If land
values in the neighborhood are $20.00 per square foot, then the excess land in this
situation would probably add the full $20.00 per square foot to the value of the sub-
ject property (i.e., the house and the two lots). If, however, the typical land area for
properties in the neighborhood is a double lot, then the same property would have
neither excess land nor surplus land regardless of building placement.
Now consider an industrial park where land-to-building ratios for warehouse
properties range from 2.8-to-1 to 3.5-to-1 and land value is $5.00 per square foot. The
subject property is a 20,000-sq.-ft. warehouse on a 100,000-sq.-ft. site, which results in
a land-to-building ratio of 5-to-1, well above the market area norm. If the additional
land not needed to support the highest and best use of the existing property is in
the back portion of the site, lacking access to the street, that land would probably be
considered surplus land because it could not be separated from the site and does not
have an independent highest and best use. In this situation, the surplus land may
still contribute positively to the value of the subject property (because the existing
improvements could be expanded onto the surplus land or this additional area might
be usable for parking or storage), but it may be worth less than the $5.00 per square
foot price commanded by vacant land elsewhere in the industrial park.
Excess land is often confused with surplus land in appraisal assignments. It is
too often lumped in with the value of the entire property or ignored altogether. While

both surplus land and excess land are not needed to support the main site and im-
provements, surplus land cannot be sold as an independent highest and best use and
excess land can be sold for its own highest and best use. Excess land may be sold off
separately from the rest of the property so that the subject property in effect becomes
two or more properties. Excess land must be addressed in the highest and best use
analysis. In contrast, surplus land cannot be sold off separately and does not have an
independent highest and best use.
Furthermore, excess land must be treated separately in the valuation process
with consideration of the cost in time and money to legally separate the parcels if
they are not already separated. An entirely different set of comparable data may be
required. Appraisers must exercise caution when adding the value of the excess land
to the value of the rest of the property because the sum of the value of the parts may
or may not equal the value of the whole. The appraisal report should display the
value of the excess land, the value of the rest of the property, and the value of the two
together as though sold in a single transaction.
Figure 12.4 Excess Land and Surplus Land
Excess
Land
16th Street
Fifth Avenue
Surplus
Land
Topography
Topographical studies provide information about land’s contour, grading, natural drain-
age, geological characteristics, view, and general physical usefulness. Sites may differ in
value due to these physical characteristics. Steep slopes often impede building con-
struction. Natural drainage can be advantageous or, if a site is downstream from other

properties or is a natural drainage basin for the area, it
Topographical characteris- may have very limited usefulness. Adequate drainage
tics, grade, drainage, and the
bearing capacity of the soil systems can be developed at some cost to offset the topo-
graphic and drainage problems that would otherwise
determine the suitability of a
land parcel for an agricul- inhibit the development of such a site. Upland land area
tural use or a proposed (i.e., land above the mean high water line) and land with
improvement. good drainage can typically support more intensive uses.
In describing topography, an appraiser must
employ the terminology used in the area. What is de-
scribed as a steep hill in one part of the country may be
considered a moderate slope in another. In some instances, descriptions of a property’s
topography may be taken from published sources such as topographic maps.
Geodetic Survey Program

Topographic maps prepared under the direction of the US Geological Survey are
referred to as quadrangles or quads. They provide information that is useful in land
descriptions. Base lines, principal meridians, range lines, and township lines are shown
along with topographic and man-made features. The topographic features commonly
depicted on these maps include land elevations (represented by contour lines at speci-
fied intervals), rivers, lakes, intermittent streams and other bodies of water, poorly
drained areas, and forest. The man-made features identified include improved and un-
improved roads, highways, bridges, power transmission lines, underground pipelines,
levees, railroads, airports, houses of worship, schools, and other buildings. Quadrangle
maps also show National Forest and Bureau of Land Management (BLM) boundaries.
Where to Find
Topographic Maps
The US Geological Survey’s US topographical maps are available for free online at the USGS Store. Historical
quadrangle maps can also be purchased from the USGS Store. For more information, visit www.usgs.gov/
products/maps/overview.
Geology and Soil Analysis

The geological conditions of a site—i.e., the composition of surface soil and sub-
soil—are important for both improved properties and agricultural land. A soil’s
suitability for building or for accommodating a septic system is important for all
types of improved property, and it is a major consideration when the construction of
large, heavy buildings is being contemplated. The need for special pilings or floating
foundations has a major impact on the adaptability of a site for a particular use. Soil
conditions affect the cost of development and therefore the property value.
Agronomists and soil scientists measure the agricultural qualities of soil and
the capacity of soil for specific agricultural uses. Engineers trained in soil mechanics
test for soil consistency and load-bearing capacity. Subsoil conditions are frequently
known to local builders, developers, and others, but if there is any doubt about the
soil’s bearing capacity, the client should be informed of the need for soil studies. All
doubts must be resolved before the land’s highest and best use can be successfully

Figure 12.5 Soil Triangle
100
90 10
80 20
70 30
Silt
60 40
,%
S
rate
epa
epa
rate
50 50
yS
,%
Cla
40 60
30 70
20 80
10 90
100
100 90 80 70 60 50 40 30 20 10
Sand Separate, %
Clay Clay Loam
Sandy Clay Loam
Sandy Clay Loam Silty Clay
Sandy Loam Silty Clay Loam
Loamy Sand Silt Loam
Sand Silt
Source: US Department of Agriculture
analyzed. A description of any general or extraordinary assumptions relating to un-

known soil conditions must be included in the appraisal report.
Structural distress in improvements such as cracks in walls or the foundation
may be evidence of geotechnical or soils problems. Estimating the cost to repair dam-
age caused by a geotechnical issue like subsidence or slope creep will usually require
the assistance of a geologist or structural engineer.1 The perceived potential for sub-
1. See Randall Bell, Real Estate Damages, 3rd ed. (Chicago: Appraisal Institute, 2016), 185-198, for more on geotechnical issues.

sidence or a more dramatic geological event such as a landslide can have an effect on
the marketability of a site, i.e., the phenomenon of stigma discussed later in this chap-
ter. Governmental geological surveys may indicate the location of past landslides.
As discussed in Chapter 7, the appraisal of mineral rights (i.e., the right to extract
natural resources found on a site) is a highly specialized appraisal assignment, and
appraisers often must work with a geologist or other expert in the mining industry.
An accurate assessment of the physical characteristics of a deposit of natural resourc-
es is critical in estimating the economic potential of the land. Note that the economic
potential of land used for agricultural purposes may be adversely affected by an
extractive industry such as oil or gas drilling on or near the site. An appraisal of sub-
surface rights requires an understanding of the geological characteristics of the land
as well as the workings of the relevant extractive industry and the investment market
for properties with natural resources.
Figure 12.6 Soil Profile
In a soil profile, the three major horizons (i.e., layers of soil with
O characteristics produced by soil-forming processes) are
A
E • A: the surface horizon
• B: the subsoil, i.e., the part of the soil that lies below plow depth
B • C: the substratum
Additional layers may include
• O: an organic horizon on the surface
C • E: a master horizon, usually between the A and B horizons, for soil with
a significant loss of minerals
R • R: hard bedrock, which is not soil
Source: http://pdfcast.net/soil-horizons-diagram.html
Where to Find
Soils Data
Soils surveys conducted by the US Department of Agriculture, along with state agricultural experiment sta-
tions and other federal and state agencies, are used to create soil maps for farmers and ranchers. For more
information, visit the Web Soil Survey at https://websoilsurvey.nrcs.usda.gov/app/.
Floodplain and Wetlands Analysis

Appraisers should check floodplain maps prepared by local governments and review
any available surveys or topographical data provided by the client. Proximity to
any flood zones may be determined by studying maps published by the Federal
Emergency Management Agency (FEMA). Each map panel is identified by a FEMA
number and shows properties within the 100-year floodplain, floodways, or other
districts (see Figure 12.9). These maps also provide base data for flood insurance rate
maps (FIRMs).

Figure 12.7 Floodplain Map
Source: https://www.exeternh.gov/sites/default/files/fileattachments/river_advisory_committee/page/42581/fema_flood_map_25.jpg

Figure 12.8 Components of a Floodplain
ay
r i n ge loodw nnel dwa
y
F F Cha Floo Fringe
Base Floodplain
Fringe Floodway Fringe
Channel
Figure 12.9 Wetlands Map
Detail from National Wetlands Mapper Website (http://www.fws.gov/wetlands/Data/Mapper.html)
The definition of what constitutes a wetland varies. Most laws describe wetlands
in terms of three possible characteristics:
1. Soils
2. Hydrology
3. Vegetation
Section 404 of the Clean Water Act, the major federal environmental legislation regu-
lating activities in wetlands, defines a wetland as land that is inundated or saturated
by surface or groundwater at a frequency and duration sufficient to support, and un-
der normal circumstances does support, a prevalence of vegetation typically adapted
for life in saturated soil conditions. Wetlands generally include swamps, marshes,
bogs, and similar areas, but classification may differ in various jurisdictions.

Swamps, bogs, fens, marshes, and estuaries are subject to varying degrees of
influence from local, state, and federal governments. In 2001, the US Supreme Court
curtailed the power of the US Army Corps of Engineers (and, by extension, other
federal authorities such as the US Environmental Protection Agency) to claim juris-
diction over certain wetlands using the Clean Water Act.2 The court ruled that the act
does not give the federal government jurisdiction over inland bodies of water that do
not flow to the sea, such as landlocked ponds, wetlands, or mud flats, only navigable
waterways or marshes that drain into navigable waters.
To value wetlands, appraisers must understand the unique features of the land,
the evolving laws protecting these areas, the niche market for such properties, and
the proper application of the approaches to value. Any uncertainty associated with
such matters should be incorporated into the appraisal.
Appraisers should look to soils and hydrology experts when necessary for credible
conclusions. Knowing in advance (i.e., before committing to a fee and timing for a specif-
ic assignment) that there is or may be a wetland issue to deal with will allow an apprais-
er to communicate with the client about what other experts may be required for credible
and supportable conclusions. Who is to engage, and pay for, these experts should be
clear from the beginning. The intended use of the appraisal is a driver for whether or not
experts will be required or whether extraordinary assumptions will suffice.
Appraisers also need to address threatened and endangered species that can be
present during only portions of the year. In 2018, the US Supreme Court ruled in favor
of the Weyerhaeuser company, one of the world’s largest owners of timberland, in a
challenge to the government’s designation of private land as “critical habitat” under
the Endangered Species Act.3 The case concerned whether the government could desig-
nate private land in Louisiana as critical habitat for an endangered species even though
the land was not currently habitat for the species and apparently could not be habitat
without significant alteration. Valuing land that may serve as habitat for a threatened
or endangered species can be a complex assignment, and the untrained eye may miss
something that could have a large effect on value. As in valuation assignments involv-
ing wetlands, either appropriate research or engaging another expert may be required.
Where to Find
Floodplain Maps
To obtain FEMA floodplain maps, contact the Federal Emergency Management Agency Map Service Center
at https://msc.fema.gov/portal/home. To order state kits and for customer service, contact the Map Service
Center at 1-877-FEMA-MAP (336-2627).
Utilities
An appraiser investigates all the utilities and services available to a site. Off-site utilities
may be publicly or privately operated, or there may be a need for on-site utility systems
such as septic tanks and private water wells. The major utilities to be considered are
• Sanitary sewers
2. Solid Waste Agency of Northern Cook County v. US Army Corps of Engineers, 531 U.S. 159 (2001).
3. Weyerhaeuser Company v. United States Fish and Wildlife Service, 586 U.S. ___ (2018).

• Domestic water (i.e., potable water, for human
The cost of installing utilities consumption)
is considered in the highest
and best use conclusion and • Types of raw or recycled water for commercial,
may be reflected directly or industrial, and agricultural uses
indirectly in the analysis, • Natural gas
depending on the selection
of comparable sales used in • Electricity
the valuation. • Storm drainage
• Telephone service
• Cable television
• Internet service
Although market analysis describes the utility systems that are available in an
area in general terms, a site analysis can provide a detailed description of the utilities
that are available to the appraised site. In a detailed site analysis, the location and
capacity of the utilities should be determined and any unusually high connection fees
should be noted. Atypically high or low service costs may need to be identified and
analyzed. It is not sufficient simply to establish which utilities are available. Any limi-
tations resulting from a lack of utilities are important in highest and best use analysis,
and all available, alternative sources of utility service should be investigated.
The rates for utility service and the burden of any bonded indebtedness or other
special utility costs should also be considered. Of particular concern to residential,
commercial, and industrial users are
• Quality and quantity of water and its cost
• Costs and dependability of energy sources (public or private)
• Adequacy of sewer facilities
• Any special utility costs or surcharges that might apply to certain businesses
• Effect of special improvement districts (SIDs) on tax rate and repayment methods
(special assessment)
Where to Find
Data on Utilities
Accurate information on public utilities can be obtained from
• Local utility companies or agencies
• Local public works departments
• Providers of on-site water and sewage disposal systems
• City and county planning departments
Site Improvements
In a site description, an appraiser describes off-site and on-site improvements. Then
the appraiser analyzes how the site improvements affect value. On-site improve-
ments include grading, landscaping, fences, curbs, gutters, paving, drainage and ir-
rigation systems, walks, and other improvements to the land. Off-site improvements
include access roads, utility hookups, remote water retention ponds, and sewer and

drainage lines. The value of off-site improvements is typically considered in the site
valuation process.
The location of existing buildings on a site must also be described and analyzed.
Many appraisers make approximate plot plan drawings that show the placement of
major buildings in relation to lot lines, access points, and parking or driveway areas.
The land-to-building ratio and overall site configuration are usually important to a
site’s appeal and ability to support specific uses. The space allotted for parking influ-
ences a site’s value for business and commercial use, so the parking space-to-building
ratio in a commercial and industrial property must be analyzed. Zoning codes or
planned unit developments (PUDs) will specify the minimum number of spaces
required, but the market ultimately decides how much parking is needed.
An appraiser considers any on-site improvements that add to or detract from a
property’s optimal use or highest and best use. For example, a lot zoned for multi-
family residential use may be improved with an 18-unit apartment building that is
too valuable to demolish. If the site as though vacant could accommodate a 24-unit
building but the location of the present structure blocks the ability to add additional
units, the appraiser may conclude that the site is underimproved and not developed
to its highest and best use as if vacant.
Accessibility
Site analysis focuses on the time-distance relationships, or linkages, between the sub-
ject site and other sites that serve as common origins and destinations. An appraiser
describes and analyzes all forms of access to and from the property and the neighbor-
hood. In most cases, adequate parking area and the location and condition of streets,
alleys, connector roads, freeways, and highways are important to land use. Industrial
properties are influenced by rail and freeway access and the location of docking fa-
cilities. Industrial, commercial, and residential areas are all affected by the location of
airports, freeways, public transportation, and railroad service.
Traffic volume may be either advantageous or disadvantageous to a site, depend-
ing on other conditions that affect its highest and best use. High-volume local traffic
in commercial areas is usually an asset. Heavy through traffic may hurt retail stores,
except those that serve regional travelers. Heavy traffic within residential areas is
usually detrimental for single-unit residential neighborhoods, but high-traffic streets
that provide access to a subdivision or development are advantageous.
The noise, dust, and fumes that come from a heavily traveled artery or freeway
are not desirable for most low-density residential lots. On the other hand, the adver-
tising value of locations on major arteries can benefit offices and shopping centers,
unless congestion restricts the free flow of traffic. The visibility of a commercial
Where To Find
Traffic Volume Data

The volume of traffic passing a property is determined by a traffic count, which can usually be obtained from
local or state departments of transportation. Traffic counts indicate average daily traffic, peak hours, and di-
rection. Observing the speed and turning movements of actual vehicles helps an appraiser judge how traffic
affects a property’s highest and best use.

property from the street is an advertising asset. This asset is most valuable when the
driving customer can easily exit the flow of traffic and enter the property.
Median strips, turning restrictions, one-way streets, and access restrictions can
limit the potential uses of a parcel. In site analysis an appraiser should test the prob-
able uses of the site in relation to the flow of traffic. Planned changes in access should
be verified with the appropriate authority and considered in the appraisal.
Environment
Appraisers also analyze land use in light of environmental conditions. Environmen-
tal considerations include factors such as
• Local climate
• Availability of adequate and satisfactory water supply
• Patterns of drainage
• Quality of air
• Presence of wildlife or endangered species habitats
• Location of earthquake faults and known slide or avalanche zones
• Proximity to streams, wetlands, rivers, lakes, or oceans
Air and water pollution are by-products of increased population and urbanization.
Public concern over pollution has prompted political action and legislation to protect
the environment. In areas subject to extreme air pollution, regulations may exclude cer-
tain industries and limit the volume of traffic. In locations near natural water sources,
industrial uses may be prohibited while recreational uses are promoted. Environmen-
Stigma
Stigma is an adverse public effect on property value produced by the market’s perception regarding a
property, commonly the identification of increased risk. This risk is derived from perceived uncertainties sur-
rounding a detrimental condition such as environmental contamination or a violent crime, which penalizes
the marketability of the property and may also result in a diminution in value. The negative perception of a
particular site may be short-term or long-term, depending on the source of the stigma and changing market
reactions to the nature of the event. Marketing times for properties affected by stigma may be longer than
comparable properties without stigma. The three significant factors in the analysis of stigma are
• The real or imagined cause of the stigma
• The duration of the effect of the stigma
• The geographical extent of the influence of the stigma
Environmental contamination such as a leaking underground storage tank is one of the most common causes
of stigma, but many other physical, economic, and legal characteristics of a site have the potential to create a mar-
ket perception that lowers value. In recent years, the effect of foreclosures in a market area on the marketability
and market value of foreclosed properties and similar area properties has been examined as a source of stigma.
Measuring the effect of stigma on value can be difficult because the damage caused by stigma is not
simply the cost to repair a defect. Focus groups, surveys, statistical analyses, case study comparisons, and
other tools have been used in this analysis. Specialized techniques are often required to estimate the effect
of stigma on property value. All of these specialized methods are based on the three traditional approaches
to value (sales comparison approach, income capitalization approach, and cost approach). Numerous stud-
ies have been conducted, and extensive appraisal literature exists, indicating that stigma may be temporary
in nature and the effects of stigma dissipate over time. Stigma has been defined in many ways in court deci-
sions, in professional standards, and in appraisal literature.

tal and climatic advantages and constraints must be analyzed to determine the proper
land use for a site. Future land uses must be compatible with the local environment.
A site in a specific location may be influenced by its exposure to sun, wind, or
other environmental factors. A very windy location can be disastrous to a resort but
beneficial to a wind farm. The sunny side of the street is not always the most desir-
able for retail shops. In hot climates, the shady side of the street often receives more
pedestrian traffic and greater sales, thus producing higher rents and higher land
values. Ski resorts almost always have slopes facing north for snow retention and
buildings facing south to receive the sun.
Analysis of a site’s environment focuses on the interrelationships between the
appraised site and neighboring properties. The effects of any hazards or nuisances
caused by neighboring properties must be considered. Of particular importance are
safety concerns—e.g., the safety of employees and customers, of occupants and visi-
tors, or of children going to and from school.
A site’s value is also influenced by nearby amenities and developments on
adjoining sites, such as parks, landmark buildings, and compatible commercial
buildings. The types of structures surrounding the property being appraised and the
activities of those who use them can greatly influence site value.
Some types of sites located in or near critical environmental features such as wet-
lands, groundwater recharge areas, or habitat for rare or endangered species may be
subject to special land use or environmental regulations that can affect values.
Contamination and Environmental Risk Issues

The presence of various types of contaminants on, adjacent to, or simply near a site
that raise environmental issues is more commonly encountered in the appraisal
process now than in the past. Some situations that can affect the value of land and
improved properties include
• Soil contamination due to an abandoned industrial plant,
• Groundwater contamination due to a leaking underground storage tank (LUST)
at a gas station or dry cleaner in a neighborhood shopping center
• Pesticide runoff from farmland into rivers and streams
• Air contamination from smoke, vapors, or odors
Contaminants and hazardous substances such as asbestos, PCBs, dioxin, TCEs, ra-
don, petroleum hydrocarborns, arsenic, lead, and other heavy metals, when present
in amounts that exceed federal or state regulatory limits, can create cost, use, and risk
issues that may reduce the market value of an unimproved or improved property.
Appraisers are not expected to have the knowledge or experience needed to de-
tect the presence of contaminants or to measure their quantities or remediation costs.
That is a job for environmental engineers and remediation specialists. But appraisers
can gain the competence and skills needed to provide an opinion of the effect of the
contamination on prices and market values by properly considering and relying on
the reports and data prepared by environmental specialists.
The consideration of environmental contamination in the appraisal process has
been specifically addressed in Guide Note 6: Consideration of Hazardous Substances
in the Appraisal Process and in Advisory Opinion 9: The Appraisal of Real Property
That May Be Impacted by Environmental Contamination, as revised by the Appraisal

Standards Board in 2002. In addition to defining key terms, definitions, and concepts,
AO-9 establishes a framework for dealing with the cost, use, and risk issues raised,
including consideration of ten important property characteristics to be considered
during an appraisal assignment.
The framework in AO-9 identifies five key steps in an appraisal assignment in-
volving contamination. First, an appraiser determines if the property is a source site,
a non-source site, an adjacent site, or a proximate site. That distinction is especially
Specialized Terms and Definitions Related to Environmental Contamination

Advisory Opinion 9, originally adopted in 1992 and substantially revised in 2002, includes the following
definitions of key terms used by appraisers who may be involved in the valuation of properties affected by
environmental issues. These definitions are also referenced in the Appraisal Institute’s Guide Note 6: Consid-
eration of Hazardous Substances in the Appraisal Process.
diminution in value (property value diminution) The difference between the unimpaired and impaired
values of the property being appraised. This difference
can be due to the increased risk and/or costs attribut-
able to the property’s environmental condition.
environmental contamination Adverse environmental conditions resulting from the
release of hazardous substances into the air, surface
water, groundwater, or soil. Generally, the concentra-
tions of these substances would exceed regulatory
limits established by the appropriate federal, state, or
local agencies.
environmental risk The additional or incremental risk of investing in,
financing, buying, or owning property attributable to
its environmental condition. This risk is derived from
perceived uncertainties concerning: (1) the nature and
extent of the contamination, (2) estimates of future
remediation costs and their timing, (3) potential for
changes in regulatory requirements, (4) liabilities for
cleanup (buyer, seller, third party), (5) potential for off-
site impacts, and (6) other environmental risk factors,
as may be relevant.
environmental stigma An adverse effect on property value produced by the
market’s perception of increased environmental risk
due to contamination. (See environmental risk.)
impaired value The market value of the property being appraised with
full consideration of the effects of its environmental
condition and the presence of environmental contami-
nation on, adjacent to, or proximate to the property.
Conceptually, this could be considered the “as-is”
value of a contaminated property.
remediation cost The cost to clean up (or remediate) a contaminated
property to the appropriate regulatory standards.
These costs can be for the cleanup of on-site contami-
nation as well as mitigation of off-site impacts due to
migrating contamination.

important to a determination of who is responsible for investigation and remediation
costs and whether that responsibility accompanies ownership of the property being
appraised. A complex network of regulations defines the environmental responsibilities
and potential liabilities of source site owners, investors, and tenants, and these respon-
sibilities and liabilities can adversely affect the value of real property interests. Second,
the appraiser considers the type of contaminant and applicable regulatory requirements
(e.g, permitted or accidental discharge, level of required cleanup), migration (e.g., soil
remediation lifecycle A cycle consisting of three stages of cleanup of a con-

taminated site: before remediation or cleanup, during
remediation, and after remediation. A contaminated
property’s remediation lifecycle stage is an important
determinant of the risk associated with environmental
contamination. Environmental risk can be expected to
vary with the remediation lifecycle stage of the property.
source, non-source, adjacent, and proximate sites Source sites are the sites on which contamination is,
or has been, generated. Non-source sites are sites
onto which contamination, generated from a source
site, has migrated. An adjacent site is not contaminat-
ed, but shares a common property line with a source
site. Proximate sites are not contaminated and not
adjacent to a source site, but are in close proximity to
the source site.
unimpaired value The market value of a contaminated property
developed under the hypothetical condition that the
property is not contaminated.
Environmental Exposure Pathways
A S N P
Adjacent Source Non-Source Proximate
Air
Safe
Storage
Surface
Vapor Well
Water
Subsurface
Source: Landmark Research

Specialized Methods and Techniques for Determining the Effects of Environmental
Contamination on Prices and Values
Over the past 25 years, the appraisal profession has developed a set of recognized and generally accepted
specialized techniques for estimating the effect of contamination and environmental risks on prices, markets,
and values as discussed in the peer-reviewed appraisal literature and courses of the appraisal profession. All
of these specialized methods are based on the three traditional approaches to value (sales comparison ap-
proach, income capitalization approach, and cost approach). Great care must be exercised when using these
specialized methods because of the special conditions and characteristics of contaminated properties. These
methods involve one or more of the following:
1. Paired data analysis of sales of impacted or potentially impacted properties
2. Analysis of environmental case studies
3. Multiple regression analysis of property sales in a potentially impacted area or in proximity to a source site
4. Adjustment of income and yield capitalization rates on income-producing properties to reflect environmen-
tal risk premiums estimated through market research
In paired data analysis, prices paid for properties that sold in an impacted area are compared to prices
paid for otherwise similar properties that sold outside the impacted area in order to estimate the effect of the
location on the sale price. Of course, no two properties are exactly alike, so market-supported adjustments
may have to be made for differences between the properties other than location. More than one pairing is
typically necessary to understand the effect of the location in the impacted area on the prices paid.
Environmental case studies are typically useful when a source site is being appraised or in a situation
involving an impacted neighborhood or area where there are insufficient sales to understand the effect of the
environmental issue on prices and values. Sales in another case study location involving a similar environ-
mental situation are studied to estimate how the marketplace there responded to similar environmental is-
sues. Typically that involves comparing sale prices in the impacted case study area to sale prices in a nearby
similar, but unaffected, control area. The case study environmental situation is then compared to that of the
impacted area using the relevant property characteristics identified in Advisory Opinion 9. Great care must
be exercised when using paired data, case studies, and interviews because of the special conditions and
characteristics of contaminated properties. Also, surveys need to be properly developed.
When properly specified and developed, a multiple regression model can be used to determine if the envi-
ronmental situation is affecting sale prices. The model can be designed to interpret the effect of issues such
as remediation status, location in a contaminated area, distance from a source site, and other factors. Of
course, model specification must also include the nonenvironmental independent variable factors (e.g., site
size, age of improvements, date of sale, zoning, school district) that influence sale prices. Having a database
that includes a sufficient number of sales to make the outcome of the model statistically significant is espe-
cially important. If the regression modeling is done as part of a mass appraisal assignment, the regression
modeling must comply with Standard 5 of USPAP.
Sale prices for income-producing properties can be studied to estimate if their direct capitalization or yield
capitalization rates have been affected by the contamination investigation, remediation, or post-remediation
circumstances, and any appropriate upward adjustment can be made to the unimpaired rate for the property
being appraised.
Given the remediation lifecycle recognized by AO-9, gathering and analyzing market data that matches
up well with the appraised property’s remediation lifecycle stage on the date of value is critical because the
effect of the contamination situation on prices and values can change as the investigation, remediation, and
post-remediation monitoring move forward.
Paired data analysis, case studies, or market studies of capitalization and yield rates developed by oth-
ers and found in published appraisal literature can be a useful starting point in such an analysis. However,
relying on published articles as a basis for a value opinion is not a recognized appraisal technique in the
absence of independent investigation and verification of the accuracy of the market data and conclusions.
Informal or formal surveys of buyers, sellers, lenders, brokers, appraisers, and others involved in actual
sales of property affected by contamination and environmental risk may also provide useful information.
For further information, see Richard J. Roddewig, editor, Valuing Contaminated Properties: An Appraisal
Institute Anthology, Vol. II (Chicago: Appraisal Institute, 2014).

contamination confined to a source site, groundwater contamination spreading off site),
and remediation (e.g., soil removal, installation of a cap, groundwater pumping, vapor
removal) characteristics. Third, the appraiser must determine the status of the property
in the “remediation lifecycle” as of the date of value. The effect of contamination and en-
vironmental risk on property prices and values changes over time; it typically decreases
as a site works its way through the discovery and investigation, remediation, and post-
remediation stages. Contamination may also be mitigated by natural attenuation even in
cases where no actual remediation efforts have been undertaken. Fourth, the appraiser
must consider the cost, use, and risk effects as of the relevant date and point in that re-
mediation lifecycle as they relate to the type of property (source, non-source, adjacent, or
proximate sites). Fifth, and finally, the appraiser estimates the impaired (“as is”) value.
In most assignments, appraisers are also asked to compare the impaired value to the un-
impaired value under the hypothetical condition that the contamination is not present.
The initial focus in the 1980s and 1990s was on techniques for appraising source
sites, for example, contaminated or remediated former steel mills or manufactur-
ing plants with on-site contamination and actual or potential off-site migration
due to surface water runoff, contaminated groundwater, or even windblown dust
and vapor. Finding comparable sales of such source properties (sometimes called
brownfields) was often difficult because many significantly contaminated source sites
did not sell until investigation had been completed, parties legally responsible for
remediation costs had been identified, remediation plans had been approved by
environmental agencies, and cleanup costs had been determined with some degree of
accuracy. Today, sales of source sites can be found and analyzed more readily. There
may also be indemnification obligations by one or more parties.
In recent years, attention has turned to techniques for estimating the value of
non-source, adjacent, and proximate sites. Sales of these types of properties can be
found in large numbers by researching markets around sites involved in documented
state or federal environmental investigations and approved remediation programs.
These transactions will usually provide sufficient basis for valuing or analyzing a site
that may be affected by environmental contamination. The details of the sales trans-
action will require a great deal of confirmation.
There are well established and generally recognized and accepted analytical
techniques and methods to determine how the cost, use, and risk factors referenced
in AO-9 affect property prices, values, and markets. Appraisers must avoid substitut-
ing their judgment for that of the marketplace. All of the techniques require consid-
eration of market data in arriving at the impaired values. Contamination does not
always have an adverse effect on value. The influence of environmental impairment
on real property must always be found in the marketplace.
Special Characteristics of Rural, Agricultural, or Resource Land

Rural or agricultural resource lands have specific characteristics that appraisers
should investigate to describe these properties adequately.
Soil
Precise soil surveys that indicate the soils found on properties, appropriate crops,
and expected production are often available (Figure 12.10). These surveys are useful
in comparing agricultural properties.

Figure 12.10 Soil Survey Map
Source: https://websoilsurvey.sc.egov.usda.gov/App/WebSoilSurvey.asp
Water Rights, Drainage, and Irrigation

The legal right to water is as important to the value of a property as the physical
source of the water. Although water rights vary greatly throughout the United States,
state laws, as administered by the state department of natural resources or another
government agency, have the greatest influence on access to water. Evidence of water
rights may be in the form of a contract with the US Bureau of Reclamation or a public
utility water distributor. Water rights may also be given by an individual state certifi-
cate or decree, by shares of stock in an irrigation company, or by location in an orga-
nized irrigation district. The long-term dependability and cost of adequate drainage
and water supplies should be analyzed. (Evaluating on-site drainage and irrigation
may require special expertise.) For an appraisal of irrigated properties, it is always
necessary to know whether the water rights are appurtenant to the land or transfer-
able separately from the land. If water rights do not transfer with the land, the prop-
erty’s value may decline significantly and its highest and best use may be changed.
Climate
General climatic conditions and growing seasons can affect crop production and se-
lection and, therefore, land value. Microclimates within a local area can also affect the
productivity of a property as compared to nearby, competitive properties.
Potential Crops
The crops grown on a property are related not only to climate, soil, and irrigation, but
also to the availability of labor, transportation, and access to the markets that make,
transport, and sell the products produced from crops.

Environmental Controls
Cropping patterns are influenced by regulations on herbicides, insecticides, fertilizers,
air and water pollution, and wildlife protection. Lead-based paint, underground storage
tanks, asbestos in farm buildings, and cattle vats are common environmental liabilities.
Mineral Rights
The presence of precious metals, oil and gas, sand and gravel, quarry red rock such
as building stone, clay deposits, or gemstones on a plot of land can affect its value. As
with water rights, the legal right to extract all minerals contained in or below the sur-
face of a property is as important as ownership of the land itself. Mineral rights may
be granted with surface rights or without surface entry because the mineral estate is
the dominant tenant in most states. Various lease and ownership relationships may
be in effect and should be investigated. These considerations are often complicated
by advances in technology and directional drilling techniques.
Because subsurface minerals can never be fully and absolutely quantified until
they are extracted, and their extent and quality are subject to many variations, apprais-
ers should recognize the risks and uncertainties associated with mineral properties.
It is also important to remember that the activity of mineral extraction is a business
activity and that real property interests must be separated from those of a business.
Unapparent Environmental Hazards

Although the environmental liabilities associated with industrial plants are well
known, many of the same liabilities may be present in other properties. Investors and
analysts cannot assume that green rural properties that appear clean are actually free
of environmental liabilities. In the 1940s and 1950s, farmers commonly used cattle
vats—i.e., trenches filled with fuel oil through which cattle were led to rid them of
mites and small insects. The fuel oil was often treated with DDT and other pesticides.
When this practice fell into disuse, the trenches were simply filled in. Farms often
have aging underground storage tanks that held gasoline used to fuel farm vehicles.
Farmland may also be contaminated by the accumulation of fertilizers and pesticides.
Old railroad beds can constitute an environmental hazard because railroad ties were
commonly soaked in creosote-filled trenches dug on site when tracks were laid. Tim-
berlands are not free of contaminants either. Old turpentine stills are often found in
areas where forests were once harvested.
Other Considerations
The location of wildlife habitats, the distances from populated areas, and the poten-
tial for recreational land uses are among the many other considerations to be ana-
lyzed in appraising agricultural land. Special tax provisions, such as reduced taxes on
agricultural or resource properties, should also be studied.4
4. For a thorough discussion of the methods used to describe and analyze the significant characteristics of land used for agricultural production,
see Rural Property Valuation (Chicago: Appraisal Institute, 2017).

Building Description 13
An important part of every appraisal is the analysis of the type, quality, and condi-
tion of the building or buildings on the site and the analysis of the structure’s design.
In the valuation process, appraisers gather much of the information needed to de-
scribe and analyze the improvements by personally visiting the site of the real estate.
Careless or inadequate inspection of the physical characteristics and features of the
subject and comparable properties can create difficulties for an appraiser in later
phases of the appraisal. For example, if a structural problem or a performance feature
that exceeds typical building requirements is overlooked, the conclusions of the three
approaches to value could be meaningless. The goal of the site visit is identifying the
site and building characteristics that create or detract from value.
Accurate building analyses are essential to all valuation assignments, even in
cases where the existing improvements do not represent the property’s highest and
best use. In the description and analysis of the site and improvements, an appraiser
should address all pertinent property strengths and weaknesses, expand on any
problem areas, and interpret the significance of the data to lay a foundation for the
discussion of highest and best use. The appraiser needs a thorough understanding
of the physical characteristics of the subject property to identify and select suitable
comparables. A thorough building analysis helps an appraiser identify the extent and
quality of building improvements, calculate their cost, and identify physical dete-
rioration and functional obsolescence. Therefore, the accuracy of building analyses
directly affects the opinion of value produced by applying the three approaches to
value. If the scope of work of the assignment does not require a site visit or calls for
an exterior-only inspection, the site and building description may not be accurate, so
the appraisal report must clearly and conspicuously disclose the extraordinary as-
sumption that the site and building characteristics are as described even though the
appraiser has not personally viewed or measured the property.
Architectural style and functional utility are interrelated, and their combined
effect on property value must be analyzed by appraisers. Architectural style is the
character of a building’s form and ornamentation. Functional utility is the ability of a
property or building to be useful and to perform the function for which it is intended,
according to current market tastes and standards. Functional utility also relates to the
efficiency of a building’s use in terms of architectural style, design and layout, traffic
patterns, performance features, and the size and type of rooms. Both architectural
style and functional utility influence the lives of individuals by providing or with-
holding beauty, comfort, security, convenience, light, and air. Building improvements
may also support reasonable maintenance expenditures, preserve valuable traditions,
or indicate the need for change.
Considerations of style and functional utility are integral to an appraisal because
they relate directly to the utility and desirability of the property in the marketplace.
They are noted along with other physical characteristics during a site visit. By using
comparable data, an appraiser can analyze how style and function influence a prop-
erty’s market value. Style and functional utility are examined in terms of (1) the use
for which a particular improvement was designed, (2) its actual or contemplated use,
and (3) its most productive use. These three uses may or may not be the same.
The ultimate goals of the analysis of the improvements are
• Proper identification of the important building components for the appraisal
analysis, i.e., what site and building characteristics influence value
• Sound judgment of the quality and condition of improvements and components
• Convincing support for conclusions in market analysis, highest and best use
analysis, and the application of the approaches to value
This chapter focuses on the structural elements and features that an appraiser will
rate in the quality and condition survey, which lays the groundwork for the analyses
that follow the building description in the valuation process.
Site Visit
Sometimes consumers equate an appraisal with the act of physically inspecting the
subject real estate, but visiting the site is just one of the many tasks that may be per-
formed during an appraisal assignment. An appraiser’s site visit, sometimes referred
to as a site inspection, differs from a property inspection conducted by a professional
property inspector and often performed prior to a sale transaction. Professional prop-
erty inspectors are specialized contractors with expertise in uncovering defects in the
structure and materials of various types of properties. They are not trained or li-
censed to render an opinion as to the impact on market value of any identified flaws,
defects, or deficiencies. Although appraisers must be familiar with the property
inspection process and may review and rely on property inspection reports, apprais-
ers observe the components and characteristics of a subject property to identify their
influence on property value in the market.
Although not every assignment requires a site visit, the importance of a site visit
should not be underestimated. Much of the primary data that an appraiser collects
comes from the process of visiting the site and observing the site and improvements.
The real estate being appraised must be understood in the context of its immediate
surroundings and the effect of other nearby improvements and land uses. Compari-
son of the subject and comparables is crucial for the sales comparison and income
capitalization approaches, and estimating building costs in the cost approach de-
pends on an accurate inventory of the building components in the subject. In addi-

tion, comparing the quality, condition, and performance of building components can
be essential in making market-derived adjustments.
In some situations, the improvements may have been demolished by natural
forces, as a result of demolition, or due to eminent domain actions. In these instances,
appraisers must ensure that they have an adequate understanding of the condition
of the improvements as they existed on the effective date of valuation. When an ap-
praiser does not know with an adequate degree of certainty the condition of a prop-
erty as of the effective date, the value is subject to an extraordinary assumption that
the property condition on that date was as it was described it in the appraisal report.
Sometimes an appraiser will not have the expertise necessary to judge the quality
and condition of specialized equipment or atypical building materials and may have
to rely on the judgment of other professionals.1 For a complex property, such as a
manufacturing plant containing sophisticated equipment and mechanical systems,
blueprints provided by the developer or owner can be helpful.
In addition to obvious property defects, appraisers should identify any new building
components such as energy-efficient upgrades and on-site energy generation facilities.
Building Description
In the valuation process, an appraiser analyzes the design, layout, and construction
details of the subject improvements, which include the structural components, ma-
terials, energy and water efficiency, and mechanical systems of each building under
investigation. The appraiser also determines the size and the function, condition, and
serviceability of each building element described.
It is also important that appraisers identify items that are not building improve-
ments, but may be important to the functionality or appeal of the real property ap-
praised. Personal property items such as window treatments and appliances may or
may not be included in an appraisal. Usually, only real property is valued, but some-
times a lender client may consider items of personal property part of the collateral for
a loan and ask appraisers to allocate a value to these items. In some instances, special
analysis may be required to determine whether items of machinery and equipment
are personal property or fixtures. The site visit offers appraisers a prime opportunity
to assess whether fixtures or other personal property are, in fact, attached to the real
estate and if they are essential to its function or marketability.
The building description provides the basis for comparing the subject property’s
improvements with improvements that are considered typical in the subject property’s
market and with the ideal improvements as determined in highest and best use analysis.
To analyze the quality and condition of improvements, appraisers need a general
understanding of the building construction process and the operation of essential
building systems.2 The typical construction materials and techniques used in a region
can change over time for a variety of reasons:
• New building technologies evolve.
• The prices of materials fluctuate significantly.
1. The Competency Rule of the Uniform Standards of Professional Appraisal Practice may apply to certain complex property inspection situations.
Advisory Opinion 2 discusses what constitutes a minimum inspection of the subject property. See also Guide Note 4: Reliance on Reports Prepared
by Others in the Guide Notes to the Standards of Professional Practice of the Appraisal Institute.
2. For an up-to-date and easy-to-read guide to construction materials and techniques, see Francis D.K. Ching, Building Construction Illustrated, 5th
ed. (Hoboken, NJ: John Wiley & Sons, 2014).

• Rising or falling energy prices make a particular building material or construc-
tion technique more desirable.
• The dictates of fashion affect the demand for a certain building material or feature.
With experience and through observation of market trends, appraisers gain insight
into how building components are perceived and valued in a particular market. The
growth of “green,” or high-performance, buildings is a good example of the changes
that occur in all types of building uses.
Elements of a Building Description

An appraiser prepares a building description by considering a variety of specific
information in sequence. Primary concerns include
1. The type of use represented by the existing building
2. The codes and regulations affecting this use
3. Building size, plan, and construction
4. Details of the building’s exterior and interior and its equipment and mechani-
cal systems (both those included in the original construction and in subsequent
improvements)
An appraiser must view a building objectively and analytically, paying careful at-
tention to all components that ultimately contribute to the determination of the build-
ing’s highest and best use as improved and any alternative uses to be considered in
the assignment. The sheer number of components listed in a comprehensive building
description should not be a factor in the application of the approaches to value. The
market’s reaction to the presence or absence of specific components in a property is
a more important consideration than the simple fact that those components do or do
not exist.
Green and high-performance buildings offer a challenge to appraisers because
their unique features may result in lower energy and water costs, differing operat-
ing costs, and improved marketability. There may also be special tax advantages or
incentives that offset the gross cost of these features. The market’s reaction to green
features may not be supportable in the sales comparison
approach because of limited sales in a given market. In
green building these cases, the income capitalization and cost approach-
The practice of creating struc- es may produce a more credible value conclusion.
tures and using processes Some improvements feature unique or special-
that are environmentally ized design, materials, or construction features that
responsible and resource-ef- distinguish them and may limit their marketability. A
ficient throughout a building’s chemical plant or a wharf facility, for example, may
life cycle from siting to de-
sign, construction, operation, have special locational characteristics that complement
maintenance, renovation, and the unique features of the improvements. Property im-
deconstruction. This practice provements with features that differ from the features
expands and complements of other properties with broader marketability are not
the classical building design necessarily without value, but more specialized analy-
concerns of economy, utility,
durability, and comfort. Also ses may be necessary. Furthermore, some properties
known as sustainable or may have special importance or value to their owners
high-performance building. or users (use value) that does not reflect the value the
property may have in its market (market value).

Use Classification
Land uses can be divided into any number of types, depending on market norms and
personal preferences. Traditionally, most appraisers have divided land uses into these
major groups:
• Residential
• Office
• Retail
• Industrial
• Mixed use
• Agricultural
• Other specialized uses
Each of these groups can be broken down into increasingly specific subgroups.
Systems of use classification may vary from market to market. For example, in
some markets hotels and motels are considered a major property classification, where-
as in other markets they are considered a subset of commercial properties. Appraisers
should be familiar with the types of property defined by the market they are working
in and employ a system of use classification that their clients will understand.
Zoning regulations establish the permitted uses of real estate. Existing and potential
land uses must be checked against zoning regulations to determine if they are conform-
ing or nonconforming uses. When the present use does not conform to current zoning
regulations, an appraiser should consider how this fact might affect property value.
Building Codes and Ordinances

In addition to any use restrictions imposed by zoning, the planning and construction
of buildings are restricted by various laws, codes, and regulations enacted at all levels
of government to protect the health, safety, and welfare of the public. Many states have
codes that control the kinds of buildings that are built there. Federal regulations are estab-
lished to ensure occupational health and safety, accessibility, environmental protection,
pollution control, and consumer protection. Municipal building codes establish require-
ments for the construction and occupancy of buildings and may contain specifications
for building materials, methods of construction, and mechanical systems. These codes
also establish standards of performance and address considerations such as structural
strength, fire resistance, energy and water usage, and adequate light and ventilation.
Many newer building codes are incorporating green and high-performance
features, particularly relating to energy and water use, as well as resilience features to
better prepare buildings to withstand natural disasters including hurricanes, floods,
and wildfires. Since build-
ing codes are periodically
updated, as frequently as Market Perceptions of Green Features
every three years, build- According to an April 2019 Realtors and Sustainability Report, nearly
ing performance for new 70% of residential and commercial realtors indicated that the listing of
and significantly renovat- energy-efficient building components was somewhat or very valuable. A
majority of home buyers were reported to be interested in sustainabil-
ed buildings may change ity, and 36% said solar panels increased the perceived value of homes.
over a relatively short The same report stated that both residential and commercial proper-
time period, even for con- ties with green certifications experienced typical marketing times.
ventional structures.

Buildings built to a
Benchmarking green standard should
Benchmarking is the practice of comparing the measured perfor- exceed the local building
mance of a device, process, facility, or organization to itself, its peers, code and should have a
or established norms, with the goal of informing and motivating per-
formance improvement. When applied to building energy use, bench- paper trail to provide the
marking serves as a mechanism to measure the energy performance details of the building
of a single building over time, relative to other similar buildings, or standard. Some govern-
to modeled simulations of a reference building built to a specific ment jurisdictions require
standard (such as an energy code). For more information, see buildings to report their
www.energy.gov/eere/slsc/building-energy-use-benchmarking.
annual energy use, which
is referenced as energy
benchmarking. Some
benchmarking databases are open to the public, providing valuable information to
appraisers and real estate agents.
Building codes establish one form of standard, but the ordinances enacted for
their application often vary from the codes themselves or place special terms or con-
ditions on how the codes will be applied in a given jurisdiction. Note that national
building codes do not always translate into local ordinances.
Size
The methods and techniques used to calculate building size vary regionally, differ
among property types, and may reflect biases that significantly affect opinions of
value. An appraiser must know the measurement techniques used in the area where
the building is located as well as those used to describe properties elsewhere. Mea-
surement techniques applied in the assignment should reflect market norms for the
property type in its market area.
The relevant type of measurement varies depending on the property type and,
more specifically, how market participants treat the measurement of that property
type. For example, net rentable area is commonly used for office buildings, while
gross living area is commonly used for one-unit residential properties.
Distinctions between gross building area, gross living area, usable area, and rent-
able or leasable area need to be clearly understood. Because the measurement of these
areas varies based on local market practices, knowledge of such practices is important.
An appraiser uses the system of measurement commonly employed in the area
and includes a description of the system in the appraisal report. Gross building area
is usually calculated. Measurements taken from plans should be checked against
actual building measurements because alterations and additions are often made after
the plans are prepared. The areas of attached porches, freestanding garages, and
other minor buildings are always calculated separately.
Standards for measuring residential property have been developed by several
federal agencies, including the FHA, the VA, Fannie Mae, and Freddie Mac (see Table
13.1). Because there is a close relationship between these agencies and the mortgage
market industry, these standards have been used in millions of appraisals. Another
widely accepted measurement standard for residential properties is Square Foot-
age—Method for Calculating: ANSI Z765-2002, developed by the National Association
of Home Builders (NAHB) Research Center with the American National Standards
Institute (ANSI).

Table 13.1 Building Measurement Standards
Gross living area (GLA)
Definition Total area of finished, above-grade residential space; calculated by measuring the outside perimeter
of the structure and includes only finished, habitable, above-grade living space. (Finished basements
and attic areas are not generally included in total gross living area. Local practices, however, may differ.)
Use Used by federal agencies to measure one-unit residential properties.
Gross building area (GBA)
Definition Total floor area of a building, excluding unenclosed areas, measured from the exterior of the walls;
includes both the superstructure floor area and the substructure or basement area.
Use Used by federal agencies to measure multifamily properties; also the common standard of mea-
surement for industrial buildings.
Gross leasable area (GLA)
Definition Total floor area designed for the occupancy and exclusive use of tenants, including basements and
mezzanines; measured from the center of joint partitioning to the outside wall surfaces.
Use Commonly used to measure shopping centers.
Note that the acronym GLA can stand for two different area measurements. Residential appraisers use GLA for gross living area; nonresidential ap-
praisers use it to refer to gross leasable area.
Office buildings present special problems for apprais-

ers because they are measured differently in different Appraisers should not accept
statements about the size of a
regions. The Building Owners and Managers Association subject or comparable prop-
International (BOMA) has established a method for mea- erty without knowing the basis
suring office building floor area. This widely used method for the calculation. Unverified
is described in BOMA’s publication Office Buildings: Stan- size information can cause
dard Methods of Measurement (ANSI/BOMA Z65.1—2017), the resulting opinion of value
to be erroneous or misleading.
which was most recently updated in 2017 as part of a ma-
jor revision to BOMA’s suite of standards.3 The descrip-
tion of an office building should include measurements of
• Gross building area
• Finished building area
• Leasable building area
Some methods of office measurement allocate a pro rata portion of the restrooms,
elevator lobbies, and corridors to each tenant. One variation also includes a pro rata
portion of the ground floor main lobby in each tenant’s leased area. Office building
management may measure single-tenant and multitenant floors in the same building
in different ways. Because these measurements vary with occupancy, appraisers must
apply a consistent method in calculating the floor-by-floor leasable area of a building.
Format
A complete building description includes information about the details and condition
of a building’s exterior, interior, equipment, and mechanical systems. If the building
3. The BOMA suite of measurement standards includes Industrial Buildings: Standard Methods of Measurement (ANSI/BOMA Z65.2—2012),
Gross Areas of a Building: Standard Methods of Measurement (ANSI/BOMA Z65.3—2018), Multi-Unit Residential Buildings: Standard Methods
of Measurement (ANSI/BOMA Z65.4—2010), Retail Buildings: Standard Methods of Measurement (ANSI/BOMA Z65.5—2010), and Mixed-Use
Properties: Standard Methods of Measurement (ANSI/BOMA Z65.6—2012). BOMA is also a founding member of the International Property
Measurement Standards Coalition (IPMSC), which was founded in 2013 to develop and implement consistent measurement guidelines for all
building types, regardless of geography. The International Property Measurement Standards (IPMS) for Office Buildings was published in 2014,
standards for residential buildings were published in 2016, and standards for industrial buildings were published in 2017. International measure-
ment standards for retail buildings are the latest in the IMPSC’s set of standards to be developed and are forthcoming.

is commissioned or certified green or energy-efficient, the details of the certification
should be described and the efficiencies analyzed. Certified green or energy-efficient
buildings usually have energy reports that provide an understanding of the perfor-
mance of the building and estimated energy savings.
Although there is no prescribed method for describing all buildings, the outline
in Figure 13.1 may be used to establish a format for building descriptions and can be
adapted to the special needs of particular assignments. For green or energy-efficient
residential buildings, the Residential Green and Energy Efficient Addendum (Figure
13.2) is an optional addendum for the URAR form widely used for mortgage lending
purposes and for the AI 820.05 Appraisal Addendum. For commercial or industrial
properties, the Commercial Green and Energy Efficient Addendum (Figure 13.3) is
the tool to use when inspecting these special buildings.
Other formats can be useful in different circumstances, depending on the type of
property concerned and the nature of the appraisal assignment. The level of detail re-
quired in the building description varies according to the assignment’s scope of work.
Description of Exterior Materials and Design

An exterior description provides information on the following:
• Substructure—foundation
• Framing
• Insulation
• Ventilation
• Exterior walls, doors, and windows
• Roofs and drains
• Chimneys
• Special features
Substructure
Substructure usually refers to a building’s entire foun-
Building Envelope
dational structure, which is below grade and includes
Building envelope refers to
the walls, foundation, roof, such foundation supports as footings, slabs, piles,
doors, and windows or those columns, piers, and beams. To evaluate the quality and
components that separate condition of footings (and other items of concealed con-
the interior conditioned struction throughout a building), which are visible only
space from the exterior un- when a building is under construction, an appraiser
conditioned space. Green or
energy-efficient buildings may must look for evidence of structural problems. Footings
have a rating for the tight- that are improperly designed and constructed often
ness of the envelope. Most cause settling and wall cracks.
high-performance buildings
will have a tighter envelope Superstructure
than required by the local
code. The lower the number,
Superstructure usually refers to the portion of the
the tighter the envelope. A building above grade. In multipurpose buildings,
very tight envelope requires a however, components such as parking garages that are
mechanical air exchange. above grade but not used for habitable space are often
considered part of the substructure.

Figure 13.1 Elements of a Building Description
A. Substructure 5. Protection against decay and insect damage
1. Footings 6. Miscellaneous and special features
2. Slabs 7. Personal property
3. Piles a. Furniture
4. Columns b. Fixtures
5. Piers c. Trade fixtures
6. Beams d. Equipment
7. Foundation walls D. Mechanical systems
B. Superstructure 1. Plumbing system
1. Framing a. Piping
2. Insulation b. Fixtures
a. Home energy rating system (HERS), noting c. Hot water system
above-standard insulation 1) Solar thermal water heating
b. Other third-party rating system 2) Hybrid water heating
3. Ventilation—mechanical air exchange (heat recovery 2. Heating, ventilation, and air-conditioning systems
ventilator [HRV] or energy recovery ventilator [ERV])
a. Heating systems
4. Exterior walls
1) Warm or hot air
5. Exterior doors
2) Hot water
6. Windows, storm windows, and screens
3) Steam
7. Facade
4) Electric
8. Roof and drain system
b. Air-conditioning and ventilation systems
9. Chimneys, stacks, and vents
3. Electrical systems
10. Special features
a. Solar photovoltaic systems (solar PV)
C. Interior description
b. Geothermal heating and cooling (ground
1. Interior walls, partitions, and doors source heat pumps)
2. Division of space 4. Miscellaneous equipment
a. Storage areas a. Fire protection
b. Stairs, ramps, elevators, escalators, and hoists b. Elevators, escalators, and speed ramps
3. Interior supports c. Signals, alarms, and call systems, energy
a. Beams, columns, and trusses dashboards
b. Flooring system (subflooring) d. Loading facilities
c. Ceilings e. Attached equipment (process-related)
4. Painting, decorating, and finishing 1) On-site energy generation (e.g., solar pho-
tovoltaics)
a. Basements
2) On-site energy storage (batteries)
b. Floor coverings
3) Resilience features such as on-site bioswales
c. Walls, partitions, and ceilings
and storm water retention and management
d. Molding and baseboards (ponds, cisterns, permeable pavement)
e. Fireplaces

Figure 13.2 Page One of the Residential Green and Energy Efficient Addendum

Figure 13.3 Page One of the Commercial Green and Energy Efficient Addendum

Substructure: A building’s entire foundational structure, which is below grade and provides a support
base or footings on which the superstructure rests.
Footings
Type Perimetric base
Materials Concrete
Characteristics/Use Most common type of footing; a concrete base rests on undisturbed earth below the frost
line and distributes the load of the walls over the subgrade.
Type Plain footing
Materials Concrete
Characteristics/Use Unreinforced and designed to carry light loads.
Type Reinforced footing
Materials Concrete and steel
Characteristics/Use Contain steel to increase their strength.
Type Column
Materials Concrete
Characteristics/Use Long, relatively slender pillars.
Type Spread footing
Materials Concrete
Characteristics/Use Frequently used where the soil has poor load-bearing capacity.
Foundations
Type Slab on ground
Materials Poured concrete
Concrete or cinder block walls on concrete footings
Cut stone or stone and brick (in older buildings)
Characteristics/Use Most common type of foundation.
Type Mat and raft (floating foundation)
Materials Concrete slab heavily reinforced with steel
Characteristics/Use Used over soils that have poor load-bearing capacity. Steel reinforcing makes the entire
foundation function as a unit.
Piles
Type Columnar units
Materials Concrete
Metal
Wood
Characteristics/Use Piles serve as substitutes for footings, transmitting loads through soil with poor load-
bearing capacity to lower levels where the soil’s load-bearing capacity is adequate.
Columns, Piers, and Beams
Materials Concrete
Steel
Characteristics/Use Foundation supports that can be used separately or in combination.

Superstructure: The portion of a building that
is above grade.
Framing
Type Platform
Materials Wood
Characteristics/Use Vertical framing members
(studs) are cut to the ceiling
height of one floor, horizon-
tal plates are laid on top,
then more studs are cut for
the next floor.
Type Post-and-beam
Materials Wood
Characteristics/Use Heavier and larger framing members support widely spaced beams. Fewer interior load-
bearing walls.
Type Precast concrete
Characteristics/Use Prefabricated walls and floors are “tilted up” at the construction site.
Type Steel framing
Characteristics/Use For functional, single-story industrial plants with large bays between columns. Usually less
expensive than precast or reinforced concrete and easier and faster to erect.
Type Solid masonry exterior walls with steel beam or reinforced concrete interior framing (newer
buildings) or interior framing of wood beams and posts (older buildings)
Insulation
Type Loose-fill
Materials Mineral wool (rock, slag, or glass wool) or cellulosic fiber (recycled newsprint, wood chips,
or other organic fibers), spray foam
Characteristics/Use Poured or blown by a machine into a building’s structural cavities.
Type Flexible
Characteristics/Use Generally used where it is not practical to install loose-fill insulation or where the foil or
kraft paper facing is needed as a vapor barrier.
Type Rigid
Materials Structural wall insulation
Fiberboard
Structural deck insulation
Rigid board insulation
Type Reflective
Materials Foil
Characteristics/Use Used to reflect heat transferred by radiation.
Type Foamed-in-place
Materials Polyurethane

Framing
The structural frame is the load-bearing skeleton of a building to which the exterior and
interior walls are attached. The structural frames of most houses in the United States are
made of wood. Many commercial and industrial buildings have steel or concrete frames.
A wood framing system that is defective can cause walls to crack, exterior walls
to bulge, windows to stick, and doors to open or close improperly. Steel framing is
usually less expensive than precast or reinforced concrete, and it is easier and faster
to erect. Steel framing has one major disadvantage, however. Unless it is encased
in heat-resistant, fireproof material such as plaster or concrete, the steel may buckle
and bend in a fire, pulling adjacent structural members out of position and greatly
increasing fire damage to the building. Reinforced and precast concrete framing is the
most expensive and difficult to construct, but it is highly resistant to fire damage.
Insulation
Insulation not only helps economize on fuel and ensure the comfort of occupants in
both warm and cold climates, but it also reduces noise transmission and impedes the
spread of fire. The ability of an insulation material to resist the flow of heat is mea-
sured in R values. R value is derived by measuring the British thermal units (Btus)
that are transmitted in one hour through one layer of the insulation. The higher the
R value, the better the insulation. There is no universal standard for the amount of
insulation required in a structure because the amount varies with the climate zone
and the type of building. For example, over-ceiling or under-roof insulation with
an R value of 13 might be satisfactory in a mild climate if there is gas or oil heat and
no air-conditioning. In cold or hot climates and in structures with electric heat or
air-conditioning, insulation with an R value of 24 might be necessary. There has been
a growing trend to superinsulate structures using insulation with much higher R
values. High-performance or energy-efficient buildings may have ratings supplied by
a third-party certifier. Residential properties may have a HERS Index that provides
the energy efficiency of the structure; the lower the rating, the more energy efficient
the home. The standard code-built house built to the 2006 International Energy Code
(IECC) has a HERS Index of 100. Appraisers can research the local building code to
find the HERS Index for the community at www.resnet.us.4 HERS ratings are most of-
ten established for new construction but can be established for existing homes. Green
or energy-efficient homes will have an index much lower than the standard 100.
Existing housing may have a home energy score (HES) on a scale of 1 to 10, with
10 representing the house that uses the least amount of energy compared to other
similar homes.5
Ventilation
All buildings need ventilation to reduce heat buildup beyond tolerances in closed-off
areas such as attics and spaces behind walls. Ventilation also prevents the condensa-
tion of water, which collects in unventilated spaces and causes building materials
to rot and decay. When condensation seeps into insulation, it reduces its R rating.
Ventilation can be accomplished with holes that range from one inch to several feet
4. The RESNET website has a database of houses with HERS scores that is open to the public. Appraisal Institute members have free access to a
more comprehensive HERS database, RESNET Appraisers Portal at https://portal.resnet.us.
5. More information on the home energy score standard is available at www.energy.gov/eere/buildings/downloads/home-energy-score.

in diameter. These holes should be covered with screening to keep out vermin. Also,
ventilation can be increased by using fans.
In green and high-performance houses and commercial buildings, energy re-
covery ventilators (ERVs) or heat recovery ventilators (HRVs) are commonly used to
provide needed ventilation for tightly sealed building envelopes. ERVs and HRVs
exchange (without mixing) the excess energy in the exhaust air with the intake air, or
vice versa, depending on whether the interior is being heated or cooled.
Construction professionals can improve indoor air quality in green buildings
by improving ventilation and minimizing off-gassing products. These goals can
be achieved by using no- and low-VOC (volatile organic compound) products and
finishes and by installing simple ventilation methods, linked fan systems, or whole-
building ventilation systems. Air filtration systems, such as high-efficiency particu-
late air (HEPA) filters, are effective in removing impurities from the air. Many air
filtration devices can also be added to existing forced-air heating and cooling sys-
tems. For green or energy-efficient buildings, reviewing the building documentation
will provide details on the indoor air quality.
Mold and Sick Building Syndrome

Many building materials—wood, drywall, insulation, carpet, textiles—contain the cellulose that various species
of fungi, commonly known as mold, feed on. The long-term effects of mold on the integrity of these build-
ing materials can cause physical deterioration. In past years the potential toxicity of the byproducts of mold
growth had been exaggerated. Nevertheless, this remains a concern and may affect value even if it does not
affect occupants’ health. This perceived problem has generated lawsuits, mainstream media coverage, and
governmental scrutiny like the attention once associated with asbestos-containing materials.
Repairing degraded building materials is usually straightforward, but the remediation of mold infestations
affecting indoor air quality can be a complex process, involving specialized enclosure and removal opera-
tions. The Environmental Protection Agency has drafted voluntary guidelines for indoor air quality and reme-
diation standards, but because of the geographical diversity of mold species, specific national regulations
defining acceptable levels of mold exposure are not practical.
A more broadly defined problem than the presence of mold is sick building syndrome, which is most
often the result of poor air circulation and is not necessarily associated with mold. In cases of sick building
syndrome, 20% or more of a building’s occupants suffer persistent physical irritation such as headaches or
respiratory problems when in the building but not when outside the building, according to the Environmen-
tal Protection Agency. The rise of sick building syndrome is commonly attributed to the energy crisis of the
1970s. The tighter building envelopes used at that time increased energy efficiency by reducing heating and
cooling costs, but an unintended side effect was a lack of air exchange, keeping possible contaminants circu-
lating inside the building longer. Modern building practices address this shortfall with enhanced attention to
building ventilation rates and moisture control, both in the building interior and within the structure itself.
The American Society of Heating, Refrigerating and Air Conditioning Engineers (ASHRAE) has taken the
lead in developing standards that are now followed by most construction professionals. Diagnosing poor
ventilation and implementing a remediation plan are difficult tasks generally performed by engineering
professionals rather than appraisers.
Exterior Walls and Doors

Exterior walls are either load-bearing or nonload-bearing. When the quality of the ex-
terior walls is below the standard for buildings in the same market, the property may
suffer a loss in value. The presence or absence of energy-conserving material such
as weatherstripping around doors should also be noted. Door shoes, weatherproof
thresholds, and sweeps will prevent air from leaking.

Exterior Walls
Type Load-bearing
Materials Solid masonry (cement block, brick, or a combination)
Poured concrete
Pre-stressed concrete
Steel beams covered with siding material
Wood framing
Characteristics/Use May be strengthened with masonry pilasters attached to the exterior of the wall.
Type Nonload-bearing
Materials Porcelain enamel
Steel
Aluminum
Precast aggregate concrete
Glass
Corrugated iron, tilt-up precast concrete asbestos board, fiberglass and metal sandwich
panels for industrial buildings
Characteristics/Use Commonly used in larger buildings; attached to the framing system.
Windows, Storm Windows, and Screens

In describing a building, an appraiser notes the type of window, its material or
manufacturer, and any energy-saving features. Because windows are a major source
of heat and cooling loss, their design and installation is important. In commercial and
industrial buildings, double- or triple-glazed windows are generally installed, and
occasionally casement windows may be used.
Facade
Many houses, stores, office buildings, and industrial buildings have a facade, or
front, that differs from the design and construction of the rest of the building. Special
facades may cost extra and could therefore affect the property’s value.
Roof and Drainage System

A roof is designed and constructed to support its own weight and the pressure of
snow, ice, wind, and rain. The roof covering prevents moisture from entering the
structure. The water that falls on a roof must be directed to the ground or into a
drainage system. Even so-called “flat” roofs may be slightly pitched to direct water to
drains and gutters.
Most roof coverings need to be replaced several times during a building’s life, so
a roof’s condition and age are investigated to determine its remaining useful life.
Chimneys, Stacks, and Vents

Exhaust systems range from simple metal vents and flues to complex masonry fire-
places, industrial chimneys, and ventilation systems. The efficiency of any fuel-burning
heating system depends on its chimney, stack, or vent. Chimneys and stacks with
cracked bricks, loose mortar joints, or other leaks may be serious fire and health hazards.

Exterior Doors
Type Standard
Materials Wood
Metal
Glass
Characteristics/Use Exterior doors are usually solid. Hollow exterior doors are generally a sign of poor-quality
construction.
Type Large truck doors (commercial and industrial buildings)
Materials Steel
Types/Components Special-purpose doors with automatic door openers
Materials Wood
Metal
Glass
Windows
Types Single- and double-hung
Casement
Horizontal sliding
Clerestory
Fixed
Awning
Center pivot
Jalousie
Materials Glass with wood or vinyl framing (usually for houses) or aluminum or steel framing (often
in residential, commercial, and industrial buildings)
Characteristics/Use Windows should be tightly sealed, with caulking at the joints and between the wall and
the window. The use of insulated glass, multiple glazing, low-E, and storm sashes helps
keep cold air out and heat in.
In most parts of the country, screens are needed for all windows that open. Most screens
have aluminum frames, and in residences screens are often combined with storm windows.
Facade
Types Multifamily
Retail
Industrial, office, etc.
Materials Masonry veneer or contrasting
siding
Glass or other decorative
material
More elaborate facade than
exterior of walls
Characteristics/Use In modern industry and
commerce, public image is By Tim1965 (Own work) [CC-BY-SA-3.0 (http://creativecommons.org/
important. An attractive store, licenses/by-sa/3.0) or GFDL (www.gnu.org/copyleft/fdl.html)], via
warehouse, industrial plant, Wikimedia Commons
or office building has both
advertising and public relations value to the occupant. Ornamentation, identifying signs,
lighting, and landscaping all contribute to a building’s aesthetics.

Roof
Types Flat
Lean-to (saltbox)
Gable
Gambrel
Hip
Mansard
Monitor
Sawtooth
Materials Wood trusses, joists or horizontal beams, joists and rafters, or posts and beams in
residential construction.
Steel or wood trusses, glued wood beams, or steel or concrete frame with wood joists
or purlins or with steel bar joists in commercial and industrial construction.
Characteristics/Use Flat roofs are used extensively in industrial and commercial buildings but are less com-
mon in residences. Lean-to roofs, often called shed roofs, are used on saltbox houses,
and gambrel roofs are popular for barns and Cape Ann and Dutch Colonial houses.
Monitor and sawtooth roofs are sometimes used in industrial construction.
Drain System
Components Gutters and downspouts
Materials Galvanized steel
Aluminum
Copper
Vinyl or PVC
Characteristics/Use Channel water from roofs to prevent damage and protect the appearance of walls when
roof overhangs are not provided.
Components Gutters or eave troughs
Aluminum
Copper
Characteristics/Use Catch rainwater at the edge of the roof and carry it to downspouts or leaders.
Components Downspouts or leaders
Aluminum
Copper
Characteristics/Use Vertical pipes that carry the water to the ground or into sewers, dry wells, drain tiles, or
splash pans.
Components Roof drains (in large buildings)
Aluminum
Copper
Characteristics/Use Connected to storm drains by pipes in the building.

Roof Covering
Materials Asphalt shingles (prevalent in residential construction)
Wood, asbestos, fiberglass, or cement shingles or shakes
Metal
Clay tile
Slate
Built-up layers of felt or composition material covered with tar and then gravel or
another surfacing material (most common on flat roofs of commercial and industrial
buildings)
Single-membrane roof assembly
Green roof system or solar system that is also the roof covering
Characteristics/Use Joints in roofs are created where two different roof slopes meet or where the roof meets
adjoining walls or projections such as chimneys, pipes, and ventilation ducts. All joints
must be flashed. Flashing is usually accomplished by nailing strips of galvanized metal,
aluminum, or tin across or under the point, applying a waterproofing compound or ce-
ment, and securing the roofing material over the edges to hold it permanently in place.
Roof Sheathing
Materials Plywood
Steel roof deck
Lightweight precast concrete slabs
Reinforced concrete slabs
Insulated sheathing in large sheets
Chimneys, Stacks, and Vents
Materials Brick
Metal
Characteristics/Use Should be structurally safe, durable, and smoke-tight; should also be able to withstand
the action of flue gases.
Special Features
Special features that must be carefully described and considered in the valuation
process might include
• Artwork that is attached to the real estate and is not personal property
• Ornamentation
• Exterior elevators
• Solar and wind equipment
• Unique window installation
• Special masonry work and exterior materials
• Items required for the commercial or industrial use of buildings
Unique building features can present a valuation problem. An appraiser must
determine if the items increase the property’s market value or are valuable only to
the current user. In the latter case, the items may add use value but little or no market
value. If such items are expensive to remove, they may not appeal to a prospective
buyer and the property could therefore lose value.

Green Building and Sustainability
In the twenty-first century, widespread public concern
over the environment and the use of natural resourc-
es has focused attention on the built environment
and the products of industry. The concept of sustain-
ability has different meanings for different constitu-
encies. Sustainability has particular resonance in the
real estate industry because of the size and impact
of the industry on national and global economies.
The United Nation’s definition of sustainability is “a
development that meets the needs of the present
without compromising the ability of future genera- A green roof can help reduce heating and cooling costs and absorbs
tions to meet their own needs.” Green building is rainwater. Wayne Senville, Planning Commissioners Journal,
the most widely recognized method for creating and www.plannersweb.com.
fostering sustainable real estate. The terms green
and high-performance are used interchangeably in many markets. Because the term green is defined differently,
appraisers must ensure they understand how the term is being used to avoid making incorrect assumptions.
Many high-performance buildings have a paper trail that can be invaluable to appraisers in adequately
describing the subject and choosing appropriate comparable sales. A commissioned building will have a
checklist used by the rater. The checklist is extremely useful in documenting the subject property details.
Not all green properties will try to obtain a certification such as LEED, Green Globes, or another third-party cer-
tification, but if the building being valued is seeking certification, an appraiser can ask for the checklist. As noted,
it provides a framework from which an appraiser can identify distinctions between the subject and its competition.
If the building has a certification from another organization, details of the certification process should be
available. Research the details of the organization to understand the rating system used. This information
will be useful in investigating comparables later in the analysis. Some certifying organizations have open
databases that can be used to research and verify the standards a property has met.
Green building encompasses a wide range of renewable construction materials, energy- and resource-
efficient building techniques, and an overriding philosophy of sustainable development. The most significant
green building practices, commonly referred to as the “six elements of green building,” relate to site, water,
energy efficiency, indoor air quality, materials, and operations and maintenance.
Site The sustainability of land (e.g., development density, stormwater management, brown-
field redevelopment). Site planning occurs during the design phase of the construction
project and encompasses two overarching ideas behind green site planning and de-
velopment: (1) to protect or restore habitat and (2) to maximize open space, providing
societal and environmental benefits. In addition, the location, solar access, shading,
landscaping, and wind are considered.
Water Water efficiency (e.g., water use reduction, landscaping). This element considers the
consumed water as well as stormwater and wastewater management.
Energy Energy and atmosphere (e.g., renewable sources, ozone depletion). By design, green
building considers the conservation of energy in the building’s design by closing the
building envelope, integrating energy-efficient mechanicals and fixtures, landscaping to
assist in shade or solar access, or using renewable energy sources such as solar, wind,
or geothermal alternatives. The AI Residential and Commercial Green Addenda offer a
solar page that presents useful information on describing a solar photovoltaic or solar
thermal system. The information provided on the solar page will allow an appraiser to
quickly and accurately establish a value for the energy produced by using Ei Value.*
Indoor air quality Indoor environmental quality (e.g., air quality, emissions, passive heating). Green build-
ing design focuses on mitigating the negative effects of off-gassing, combustion-based
appliances, and moisture. A tightly sealed envelope requires mechanical ventilation to
achieve good indoor air quality.
Materials Materials and resources (e.g., reuse, recycling, renewable materials). The materials
used can have a significant effect on indoor air quality. Green buildings use materi-

als that are less toxic than their conventional counterparts and thus do not off-gas as
much. Additional considerations include durability, material reuse and recycling, and
the use of recycled and rapidly renewable resources as well as where and how the
materials are manufactured.
Operations and Innovation and sustainable design includes measures to control water and energy
maintenance consumption along with the use of durable materials and designs that are meant to
lower maintenance costs while lengthening the lives of building components.
Measuring the effectiveness of green building efforts is difficult. Sustainability is not always easy to mea-
sure at the property level, and many experimental materials and methods have not proven to be physically or
economically sustainable. Many local governments have created sustainability plans with incentive programs
to reward owners and developers of green buildings. A useful website for researching incentives and rebates
available at the federal and local levels is www.dsireusa.org. A recognized professional standard is the Lead-
ership in Energy and Environmental Design (LEED) standard for sustainable development. Possible impacts
on the valuation process include the following:
• The financial feasibility and productivity of sustainable construction and design elements could affect
highest and best use analysis. As a market moves toward green building standards, the highest and best
use should discuss the financial feasibility of incorporating these features.
• The higher cost (perceived or actual) of sustainable building materials and more efficient equipment and
systems can add to the cost of construction indicated in the cost approach. RS Means currently publishes
a green building project planning and cost estimating manual (see http://rsmeans.reedconstructiondata.
com). The distinction between cost and value becomes a critical consideration when green building materials
and systems are involved. In the debate over the benefits of green building, the essential question is: Is the
added expense worth the perceived additional cost to a typical property owner or investor in the market-
place? The use of the terms gross cost and net cost should be analyzed. Gross cost is affected by incentives
and tax credits attributed to green building, which often offset a portion of the added costs and result in a
lower net cost of green building. Furthermore, an argument could be made that a lack of sustainable features
in a new building is a functionally obsolete design in a market that expects green building features. Likewise,
the perceived lifespan of sustainable building components may need to be accounted for in cost estimates if
the market participants expect the sustainable features to last longer than traditional components.
• In the income capitalization approach, the reduced operating expenses of a building with energy- and
water-efficient, low-maintenance features may have a positive impact on effective gross income, and
thereby value. Overall operations and maintenance expenses should be less than the expenses of a code-
built structure. Care must be taken to select income and expense comparables that have similar features.
• As green building becomes accepted and then expected in a market, the presence or lack of green building
features in a subject or comparable property could affect the selection of comparable properties, adjustment
for physical characteristics, and other aspects of the application of the sales comparison approach.
In a market value appraisal assignment, appraisers have a professional obligation to provide an inde-
pendent and objective opinion of value and so must distinguish the social and governmental influences on
the value of sustainable improvements from the value the market ascribes to those improvements. The sales
comparison approach may not provide a credible value opinion until the market has sufficient sales data.
Additional Resources
US Green Building Council (www.usgbc.org)
Green Building Initiative (www.thegbi.org)
Energy Star (www.energystar.gov)
Energy Benchmarking (www.buildingrating.org/graphic/us-commercial-building-policy-comparison-matrix)
New Building Institute (https://newbuildings.org/)
Sandra K. Adomatis, Residential Green Valuation Tools (Chicago: Appraisal Institute, 2014)
Timothy P. Runde and Stacey L. Thoyre, The Valuation of Green Commercial Real Estate (Chicago: Appraisal
Institute, 2017)
* For more information on Ei Value, see www.eivalue.com.

Description of Interior Materials and Design
An interior description provides information about
• Interior walls, partitions, demountable walls, and doors (including how the space
is divided)
• Interior supports
• Stairways
• Painting, decorating, and finishing (including floor and ceiling coverings)
• Protection against decay and pests
Interior Walls, Partitions, and Doors

Like exterior walls, interior walls and partitions can be either load-bearing or non-
load-bearing. In general, having fewer load-bearing interior walls allows for greater
flexibility in the division of space within the structure.
Interior Supports
A building description includes consideration of the building’s internal supports,
which include
• Beams, columns, and trusses
• The flooring system
Division of Space
A building description provides a complete list of the number of rooms in the structure and their uses. Room
sizes may also be stated. The number of bedrooms and bathrooms in a residential property usually influ-
ences the market for the property and its value. The number of units in an apartment building and the types
and sizes of the rooms within the units significantly influence the property’s income-producing potential.
Similarly, the amount of office space in an industrial property and the partitioning of office suites may affect
property value if the office percentages or location are not suitable to market participants.
In certain parts of the United States, many types of buildings have basements. Basement areas can be
finished or unfinished, and in many markets the value is equal to the depreciated cost. However, there are
places where the market does not recognize the value of basements as equal to their physically depreci-
ated cost, and the values are diminished. Usually, if an analysis of similar properties shows an overwhelming
percentage of the buildings have basements, the buyers in that market were willing to pay to add that feature.
If nothing has changed, the basements should be worth what they cost less physical depreciation.
In a residential condominium building, the condominium declaration will identify the unit, the limited com-
mon elements, and the common elements. The condominium declaration will also identify the percentage of
ownership in the common elements of the association.
Storage Areas
Homeowners often complain about a lack of adequate storage space, especially in kitchens. Ample cabinets,
closets, and other storage areas are important, particularly in homes without basements. Storage is particu-
larly important in multifamily residential buildings. The value of apartment and condominium projects is often
enhanced by the availability of storage space. Frequently, mini-storage facilities are located near apartment
complexes because apartment units often have inadequate storage space. Storage problems can also exist
in commercial and industrial buildings.
One of the most important things to remember about storage or closet space is that it takes away area
from the rest of the structure. For example, if an 1,800-sq.-ft. house has a great deal of closet space, then
the room sizes must be smaller to fit within the same area. In other words, big closets take away from the
room sizes if the gross living area is the same.

• Ceilings
Beams, Columns, and Trusses

Beams and columns are used in many residential, commercial, and industrial build-
ings with basements or crawl spaces that are too wide for the first-floor joists or
subfloor systems and cannot be supported by the foundation walls alone. As interior
support systems, traditional joist construction is being replaced by both roof and
floor truss systems.
Flooring System
Subflooring provides safe support for floor loads without excessive deflection and
an adequate base for the support and attachment of finished floor material. Bridging
stiffens the joists and prevents them from deflecting.
Ceilings
In some structures, the underside of the upper story is an adequate ceiling. Apprais-
ers typically measure and consider ceiling height.
Stairs, Ramps, Elevators, Escalators, and Hoists

Designing and constructing even the simplest staircase is complicated. Local building
codes dictate the minimum and maximum tread and rise of stairs, which should be
consistent within a building. The Americans with Disabilities Act of 1990 (ADA) estab-
lished accessibility guidelines, and buildings accessed by the public that do not meet
those regulations may suffer a value penalty based on the cost of necessary changes.
In multistory buildings, appraisers must evaluate how efficiently the elevators
and escalators in the building move people and freight. The elevators and escalators
in many multistory buildings are inadequate and fall short of current market stan-
dards. Curing these deficiencies is often expensive or impossible. Hydraulic elevators
usually have lift posts with oil lines and cylinders in the ground, and leaks can go
undetected into the ground.
Americans with Disabilities Act

An appraiser cannot assume that improvements comply with the requirements of the Americans with Dis-
abilities Act (ADA) of 1990. Enforcement of the requirements can be triggered by a change in use or a title
transfer. Owners of older properties may have to add ramps, elevators, or other special equipment to comply
with ADA regulations, which can affect value greatly.
Along with related legislation such as the Fair Housing Amendments Act of 1988 and the Uniform Federal
Accessibility Standards, ADA extends protection under civil rights laws to people with disabilities. Among
other provisions directed toward employment opportunities, the legislation guarantees access to places of
public accommodation to persons with disabilities. Specifically, Title III of the act, which deals with “places
of public accommodations” and “commercial facilities,” is of particular importance to appraisers. Govern-
ment publications regarding ADA are available online at www.usdoj.gov/crt/ada/publicat.htm, and the ADA
information line is 800-514-0301 (voice) or 800-514-0383 (TDD).
A real estate appraiser is not required to become an expert in the field of ADA requirements, but the Compe-
tency Rule of the Uniform Standards of Professional Appraisal Practice requires appraisers to have the knowledge
and experience necessary to complete a specific assignment competently or to disclose the lack of knowledge
and experience to the client, take all steps necessary to complete the assignment competently, and describe
their lack of knowledge or experience and the steps taken to competently complete the assignment in the report.
For an overview of specific requirements of ADA in building design, see the ADA website(www.ada.gov).

Special elevators and hoists are often considered part of a building, although
they may be studied under the equipment category.
Interior Description
Walls
Type Residential buildings
Materials Wood studs covered with drywall materials (gypsum board, wood panels, ceramic tile,
plywood, hardboard)
Plaster (less popular now)
Masonry (in masonry houses)
Structural insulated panels (SIPs)
Insulated concrete forms (ICFs)
Characteristics/Use Interior walls can be painted, papered, or decorated in other ways.
Type Commercial buildings
Materials Wire partitions
Glass
Wood
Plywood
Hardboard
Metals
Tile
Concrete
Solid masonry walls for fire protection
Characteristics/Use Interior walls can be painted, papered, or decorated in other ways.
Partitions
Materials Various materials
Characteristics/Use Generally non-load-bearing and movable.
Doors
Types Simple hollow-core doors in most residential construction
Solid-core doors in older buildings and office buildings
Complex, self-closing, fire-resistant doors in commercial and industrial buildings
Specialty, self-opening and -closing doors in offices and commercial buildings
Special-purpose doors (e.g., doors to bank vaults)
Characteristics/Use Hanging a door is complicated and often done improperly. Most poorly hung doors
close improperly or fail to touch an edge of the frame when closed.
Interior Supports
Types Beams
Columns
Trusses
Materials Wood, masonry, concrete, or steel
Characteristics/Use Designed to support heavy loads. Cracked or sagging beams may be an early indica-
tion of more serious problems in the future.

Type Flooring system
Materials Generally wood or concrete
Characteristics/Use Serves as a base for floor covering.
Type Ceiling
Materials Same material as interior walls (e.g., gypsum), tile, or underside of upper floor
Characteristics/Use Ceilings that are too high or low for the property’s current highest and best use as
improved may be considered items of functional obsolescence and decrease the prop-
erty’s value.
Stairs and Ramps
Type Residential buildings
Characteristics Provides for safe ascent and descent, with adequate headroom and space for moving
furniture and equipment. Railings should be installed on the sides of all interior stair-
ways, including stairways in attics and basements, where they are often omitted.
Type Public buildings
Characteristics Codes often regulate where stairs are located, how they are designed and constructed,
and how they are enclosed for fire protection. Public buildings may also have to be
barrier-free to provide access for handicapped people as mandated by the Americans
with Disabilities Act of 1990 (ADA), which may require that ramps be installed both
inside and outside the structure.
Painting, Decorating, and Finishing

Most buildings are decorated many times during their useful lives. An appraiser re-
ports the condition of the painting and decorating in a structure and notes when they
will need to be redone. The attractiveness of painting and decorating is subjective.
Many new owners and tenants will redecorate to suit their personal tastes. Unusual
decorations and colors may have limited appeal and, therefore, may detract from a
building’s value. The quality of decoration is sometimes an important consideration
in valuing a restaurant, store, or other commercial building.
Some considerations of interior finishes and decorating include the following:
• If finished basements are used for purposes other than storage and these uses are
accepted and typical in the area, they can add significantly to the property’s value.
• The types and finishes of various wall and ceiling components should be differ-
entiated.
• A wide variety of flooring is available, and some flooring materials are selected
primarily for their low cost and durability. An appraiser should consider whether
floor coverings can endure wear and tear and how they conform to a building’s
design and decoration. Green buildings may use floor coverings that have low
volatile organic compound (VOC) concentrations, are more durable than conven-
tional materials, are made from recycled materials, or are recyclable.
• Green buildings use low- or no-VOC paint to provide better indoor air quality.
• Unique, restored molding can add value to older houses, but the use of moldings
is decreasing.
• Most fireplaces in homes and commercial buildings, such as restaurants, inns,
and specialty stores, do not provide the building’s primary source of heat. In fact,

because of their design, many have little heating power. Because fireplaces are
difficult to construct, many are badly made and function poorly. One common
problem is downdraft, whereby smoke is blown into the building by the wind
outside. This can happen if the chimney does not extend at least 2 feet above any
part of the roof within 10 feet of the chimney.
Interior Painting, Decorating, and Finishing

Basement Finishes
Types Unfinished, used for storage
Finished (in residences and some commercial buildings), used for storage and other
purposes
Characteristics Dampness, which is often a problem in basements, may be caused by poor foundation
wall construction, excess groundwater that is not properly drained by ground tiles, poorly
fitted windows or hatches, poor venting of equipment, or poorly constructed or operating
roof drains that allow water to enter. Signs that may indicate a wet basement include a
powdery white mineral deposit a few inches off the floor, stains near the bottom of walls
and columns or equipment that rests close to the floor, and the smell of mildew.
Flooring and Floor Coverings
Components Sand, compressed dirt, bituminous paving, brick, stone gravel, concrete, and similar
products
Characteristics Suitable for many industrial buildings, warehouses, garages, and basements. In many
commercial and industrial buildings, floors must be especially thick or reinforced to
support heavy equipment.
Components Terrazzo flooring
Characteristics Made of colored marble chips that are mixed into cement and ground smooth; used for
high traffic areas such as the lobbies of public buildings.
Components Wood in various forms
Characteristics Continues to be a popular material for floors. Planks and blocks are used for industrial
floors, and many commercial buildings use wood floors to conform with the design and
overall decoration. Wood planks and hardwood strips are found in many residences.
Components Resilient, ceramic, stone, and quarry tiles.
Characteristics Used in all types of buildings.
Components Resilient flooring
Characteristics Usually a combination of vinyl and asphalt or laminate produced as sheet goods.
Components Carpeting
Characteristics Once considered a luxury in residences, offices, stores, and commercial buildings, but
today is widely used in all types of buildings.
Interior Wall Coverings and Ceilings
Types Walls and partitions
Characteristics May be painted, papered, or paneled. Supplemental finishes include ceramic tile and
wainscot paneling.
Types Ceilings
Characteristics Can be drywall, plaster, or suspended panel (drop ceilings).
Types Partitions
Characteristics Can be wood or metal.

Protection Against Decay and Insect Damage
All wood is susceptible to decay and insect damage. When wood is consistently
exposed to moisture and water, destructive organisms propagate on or beneath its
surface. Insects damage wood more rapidly and visibly than decay does. Although
several species of insects destroy wood, termites are by far the most destructive to
both damp and dry wood. They colonize in moist soil or in dry wood and create
infestations that are extremely difficult to eradicate.
Builders employ various techniques to protect against decay and insect damage:
• Sloping the ground away from foundations for good drainage and putting vapor
barriers on the interior sides of exposed walls
• Using polyethylene as a soil cover in crawl spaces
• Flashing, gutters, downspouts, and splash blocks to carry water away from foun-
dation walls
• Using poured concrete foundation walls, concrete caps over unit masonry foun-
dations, wood treatments, soil treatments, or metal termite shields
Building with dry, naturally durable woods and conducting regular maintenance
inspections can also help prevent insect infestation and damage. Poorly aimed lawn
irrigation systems can be a serious problem for improvements if the water collects
against the foundation or is directed at exterior walls or windows. An improperly
installed irrigation system can rot a window assembly or cause a mold problem in
only a few years.
Miscellaneous and Special Features

In valuing industrial and commercial properties, an appraiser may find it helpful to
distinguish between two categories of equipment:
• Equipment and mechanical systems that provide for human comfort—e.g.,
plumbing, heating, air-conditioning, and lighting
• Fixed building equipment that is process-related—e.g., air hoses, process piping,
craneways, bus ducts, heavy electrical lines, and freezer equipment
Because different users of structures and related improvements frequently adapt
them for their own particular needs, some elements may not be suited for other users
and therefore will not contribute to market value. Limited-market properties may
require additional research because less data is available to support the utility and
market acceptance of extra or unusual elements of the improvements.
Some properties with specialized functions and design features that may require
additional research include
• Steel mills
• Oil refineries and ethanol plants
• Chemical plants
• Concrete factories
• Mines
• Commercial establishments with unique design features (e.g., drive-in restau-
rants) or special facilities (e.g., the cooling room in a furrier’s shop)
• Amusement parks

• Sports complexes
• Wharves and docks
• Transportation terminals
• Television and radio transmission towers, studios, and theaters
Personal Property
During a site visit, an appraiser may also find personal property, sometimes referred
to as “furniture, fixtures, and equipment (FF&E).” Certain types of real property
include a substantial amount of personal property. Examples include the following:
• Hotel properties include guest room and common area furnishings, pool and fit-
ness equipment, and other items.
• Convenience stores and retail fuel properties have gas pumps, canopy, signage,
and lighting outside as well as shelving and food service equipment inside.
• Nursing homes include furniture, medical equipment, specialized bathing equip-
ment, physical therapy apparatus, walkers and wheelchairs, hospital carts, and
other equipment.
• Apartments include dishwashers, stoves, refrigerators, washer and dryers, and
sometimes window coverings.
• Residential properties may have leased solar photovoltaic systems, power pur-
chase agreements, or owned systems that are financed through a solar loan that
holds the system as collateral. Such systems have a Uniform Commercial Code
(UCC) filing and are personal property so they should not be included in the real
estate value. In fact, the existence of a long-term lease or power purchase agree-
ment requires an analysis to understand the terms of the agreement and how it
may affect the real estate.
These non-realty components should be identified and the appraisal report should in-
dicate if they are or are not included in the ownership interest of the subject property.
In appraisals prepared for certain types of litigation, such as eminent domain and
property tax appeals, appraisers must be familiar with case and statutory law related
to fixtures and other non-realty-related property.
Equipment and Mechanical Systems

Most buildings cannot perform the functions for which they were designed and con-
structed unless their equipment and mechanical systems are in working order. Major
equipment and mechanical systems include
• The plumbing system
• The heating, ventilation, and air-conditioning (HVAC) system
• The electrical system
Plumbing System
Plumbing is an integral part of most buildings. It consists of supply, waste, and vent
piping (which is usually covered or hidden except in industrial buildings) and fix-
tures and fittings (which are visible). Laundries, laundromats, and certain industrial
buildings have elaborate plumbing systems.

Plumbing System
Piping
Types Supply pipes
Waste pipes
Vent pipes
Materials Copper, cast iron, or plastic
Characteristics/Use Galvanized steel, lead, or brass pipes in older buildings may need to be replaced.
Bathroom Fixtures
Types Lavatories (or washbasins)
Bathtubs
Showers
Toilets (or water closets)
Bidets
Urinals
Materials Cast iron covered with acid-resistant vitreous enamel, or porcelain (fiberglass or other
materials are also used in lower-quality fixtures)
Types Sinks (or double sinks)
Materials Porcelain, metal, stainless steel, enameled steel, or cast iron covered with acid-resis-
tant enamel
Kitchen Fixtures
Types Sinks (or double sinks)
Garbage disposals
Dishwashers
Materials Monel metal, stainless steel, enameled steel, cast iron covered with acid-resistant
enamel, or porcelain
Other Fixtures
Types Instant hot water units
Laundry tubs
Wet bars
Swimming pools or saunas
Janitor sinks
Drinking fountains
Handwashing and eye-washing fountains
Fittings
Types Faucets
Spigots
Drains
Shower heads
Spray tubes
Floor drains in industrial buildings
Characteristics/Use The water in an area may be hard—i.e., it may contain minerals that react unfavorably
with soap and make it difficult to rinse from clothing, hair, and skin. Often hard water
cannot be used until it is treated, either with simple equipment or with automatic,
complex, multistage systems.
Recycled water systems convert gray water (wastewater) into recycled water for use in
landscaping. Cisterns and rain barrels are another form of water catchment for reuse
on site.

Piping
Much of the cost of a plumbing system is due to piping. The quality of the materi-
als used, the way the pipes were installed, and how easily they can be serviced are
significant considerations in estimating how long the pipes will last and how much
they will cost to maintain. In many areas and for many building types, a high-quality
piping system will last as long as the building.
Fixtures and Fittings

Appraisers must decide which building fixtures are part of the real estate and which
are personal property. The design of bathroom fixtures can change substantially over
time, and old fixtures may become obsolete during a building’s economic life. An
appraiser should report the need for modernization, but old fixtures of good quality,
such as porcelain pedestal basins and footed tubs, are often rehabilitated and valuable.
Hot Water System

All homes and most commercial and industrial buildings need an adequate supply of
hot water. Buildings with inadequate hot water systems suffer from functional obso-
lescence. The size of the hot water storage tank needed is determined by the number
of occupants and their water-using habits and by the recovery rate of the tank. The
size and recovery rate of a storage tank may be limited to what the market will pay
for. Many new and remodeled homes have tankless hot water systems. Commercial
and industrial buildings often require much more hot water than homes.
Hot Water System

Types Self-standing heater (in residential buildings)
Large cast iron or steel boiler and storage tanks (in commercial and industrial build-
ings)
Tankless systems, hybrid water heating systems, solar thermal water heating systems
Characteristics/Use Generally powered by electricity, gas, or oil.
Heating Systems
Most heating systems use warm or hot air, hot water, or steam and are powered by
fuel oil, natural gas, electricity, or coal. The heating capacity required relates to the
cubic content, exposure, design, and insulation level of the structure to be heated and
appropriate standards for the local market area. Appraisers cannot assume that a
building’s heating system is adequate. A heating system installed at the time of con-
struction may not be acceptable to potential buyers today. New technology continues
to reduce energy consumption for large heating systems. Many industrial users who
once depended on gas alone now install more efficient oil or electric systems to pro-
vide heat when the gas supply is curtailed. Electric heat has become so expensive in
some areas that buildings using it sell for substantially less than similar properties us-
ing other types of fuel. Cogeneration, the simultaneous production of electrical energy
and low-grade heat from the same fuel, is also being used in some parts of the country.
Property buyers and users are sensitive to energy costs and are becoming more
aware of energy ratings and energy modeling reports. In some markets, apartments
in which the owner supplies heat and hot water will sell for less than similar proper-

Heating Fuels: The type of fuel used in a building’s heating system should be explained in the building
description. Depending on the area and the type of building, one type of fuel may be more desirable than
another. Nevertheless, many building heating systems do not use the most economical fuel. For any specific
use, different fuels have different advantages and disadvantages, which are subject to change.
Type Characteristics
Fuel oil Despite its high cost, fuel oil is a popular energy source that is easy to transport and
store. On-site, 275-gallon tanks are used in millions of houses, and tanks that hold
thousands of gallons of fuel oil are buried on industrial and commercial sites.
Natural gas Natural gas is a convenient type of fuel because it is continuously delivered by pipe-
lines; no storage tank is needed. In many parts of the United States, natural gas is the
most economical fuel. Liquid petroleum gas, such as butane and propane, is used in
many rural areas. It requires on-site storage tanks and is usually more expensive, but in
other respects it is similar to natural gas.
Electricity Like oil, gas, or coal, electricity can be used to produce heat in a furnace or to heat
water in a boiler. In most areas electrical heating costs are high, but good insulation
and control can eliminate waste.
Coal In the past coal was the most popular fuel for heating. It is still used in electrical
generating plants and to generate power for some industrial and commercial uses. Coal
is also used in residences for stoves and fireplaces, but the burning of certain types of
coal creates environmental pollution.
ties in which tenants pay for utilities. Buildings that have high ceilings, many open-
ings, and poor insulation may be at a disadvantage in the market.
Air-Conditioning and Ventilation Systems

The most common type of air-conditioning system consists of an electrically powered
compressor that compresses a coolant from gas into liquid outside the area being
cooled. The heat released in this process is either blown away or carried away by
water. Air-conditioners range from small, portable units to units that provide many
tons of cooling capacity.
Commercial and industrial air-conditioning and ventilation systems are more
complex. Some simply bring in fresh air from the outside and distribute it through-
out the building. Others merely remove foul air. Still others combine these two func-
tions, but do not have any cooling or heating capacity. More complex systems wash,
filter, and add or remove humidity from the air. The most complex systems perform
all of these functions and also heat and cool air through a complex system of ducts
and fans. In larger systems that use less electricity, water cools the pipes in which the
gas has been compressed. The water is then conserved in towers that cool it for reuse.
Electrical Systems
In an electrical system, power is distributed from the electrical service station
through branch circuits, which are wires located throughout the building, to electrical
outlets. Each branch circuit starts at a distribution box, where it is separated from the
main service by a protection device such as a fuse or circuit breaker.
In commercial and industrial buildings, the wiring between the distribution boxes
and the outlets is usually a rigid or flexible conduit. In most houses BX or armored cable
is used. Plastic-coated wire is used in certain areas, and the old knob-and-tube wiring is
still found in rural areas and older buildings, although it is considered obsolete.

HVAC System
Heating System Heating is rated in British thermal units (Btu).
Types Warm or hot air
Characteristics/Use Air heated in a furnace and circulated by a pressure blower or relying on the force of grav-
ity. May include thermostats, filters, humidifiers, air cleaners, and air purification devices.
Types Hot water (or hydronic systems)
Characteristics/Use Hot water pumped by a circulator through pipes to radiators and cold water is returned
to the boiler to be reheated. In radiant heating systems, hot water is pumped through
narrow pipes embedded in floors, walls, and ceilings rather than through radiators.
Types Steam
Characteristics/Use Produced by a boiler, distributed through a one-pipe gravity system (identical to the
piping used in hot water systems), and transferred through radiators. More complex and
expensive two-pipe systems are found in larger, high-quality structures. In many states,
licenses are required for certain classes of steam boilers. Appraisers must be familiar
with local boiler license laws and ascertain whether boilers have current, valid licenses.
Types Electric
Characteristics/Use Includes heat pumps, wall heaters, baseboard units, duct heating units, heating units
installed in air-conditioning ducts, and radiant heat produced by electric heating ele-
ments embedded in floors, walls, and ceilings. The automatic regulation of a heating
system helps it operate efficiently. A multiple-zone system with separate thermostats is
more efficient than a single zone system with one thermostat. Complex systems provide
an individual temperature control for each room. The efficiency of certain systems can
be increased by putting a thermostat on the outside of the building. This helps building
operators anticipate how much heat the system will need to produce.
Air-Conditioning and Ventilation System
Types Electrically powered compressor and non-ozone-depleting refrigerant
Gas-powered compressor and ammonia as coolant
Combination with water-cooled pipes in which gas is compressed
Characteristics/Use Standards depend on climate. Capacity is rated in tons of refrigeration. In some build-
ings the central air-conditioning equipment uses the same ducts as the hot air heating
system. This is not always possible, however, because the air-conditioning may require
ducts of a different size. Furthermore, heating registers should be placed low on the
walls, while air-conditioning registers should be higher up or in the ceiling.
Large-capacity power wiring may contribute to the value of an industrial im-

provement. However, if the wiring is an uncommon type and adds to a building’s
operating costs or will be expensive to remove, it may result in functional obsoles-
cence. Similarly, any building with insufficient electrical service or wiring suffers
from functional obsolescence.

Electrical System
Components Rigid or flexible conduit
BX or armored cable
Characteristics/Use Most electrical wire is copper. A typical residential electrical system is a single-phase,
three-wire system that provides a minimum of 100 amperes of electricity. Ampere
services of 150, 200, 300, and 400 are needed when electric heating and air-con-
ditioning are used. Most of these services can provide up to 220 volts by connecting
three wires to the outlet.
Components Power wiring
Characteristics/Use Used in commercial and industrial buildings to operate utility systems, appliances,
and machinery. The electrical power is generally carried at higher voltages (e.g., 240,
480, 600 volts or more) and higher amperages (e.g., 400, 800, 1,200 amperes or
more). Power wiring is usually three-phase or three-phase-four-wire, which allows both
lighting and three-phase power loads to be delivered by the same supply. It is carried in
conduit or by means of plug-in bus ducts. Overhead bus ducts are frequently found in
manufacturing plants where flexible service is needed.
Components Switches and lighting fixtures
Characteristics/Use Because lighting fixtures are stylized and styles change, they are often obsolete before
they wear out. Fluorescent lighting, which may be suspended, surface-mounted, or
recessed, is used extensively in commercial and industrial buildings. Often continuous
rows are used in large spaces. Incandescent fixtures may be used for smaller rooms,
accents, or special purposes. Sodium, mercury vapor, halogen, and halide lights are
often installed in industrial buildings.
Components Outside, yard, and parking lot lighting
Characteristics/Use Usually downlighting of some kind; often mercury vapor, halogen, or halide lights.
Components Floor outlets or floor duct systems
Characteristics/Use Used extensively in commercial and office buildings; provide convenient electrical outlets
for office machines and telephone outlets at desks using a minimum number of cords.
Components Low-voltage switching systems
Characteristics/Use In some houses and commercial buildings; allow many outlets and lights to be con-
trolled from one place.
Miscellaneous Equipment
In the building description, an appraiser must also consider miscellaneous equip-
ment, such as
• Fire protection
• Elevators, escalators, and speed ramps
• Signals, alarms, and communication systems
• Loading facilities
• Attached equipment
• Reclaimed water systems
• Solar photovoltaic (PV) systems (see Figure 13.4)
• Energy storage (batteries)

Miscellaneous Equipment
Fire Protection
Components Fire escapes
Standpipes and hose cabinets
Alarm services
Automatic sprinklers
Characteristics/Use A wet sprinkler system must have adequate water pressure to ensure that the pipes
are always filled. A dry system has pressurized air in the pipes. When a sprinkler head
opens, the pressure is relieved and water enters. Dry systems are used on loading
docks, in unheated buildings where there is a danger of water freezing, and in areas
where there is no city water (usually because a well cannot supply sufficient pressure
to operate a wet system).
Elevators
Type Passenger
Characteristics/Use Generally electric. Most modern elevators are high-speed and completely automatic.
Type Freight
Characteristics/Use Electric or hydraulic. Hydraulic elevators are suitable for low-speed, low-rise operations.
Escalators and Speed Ramps
Type Passenger
Characteristics/Use Used to move large numbers of people up and down or along horizontal or gradual
slopes; must be adequate to accommodate those who use the building.
Signals, Alarms, and Communication Systems
Components Smoke and carbon monoxide (CO) detectors
Characteristics/Use Required by law in many areas.
Components Security alarm systems
Characteristics/Use Available for residential, commercial, and industrial use to warn occupants of forced
entry, fire, or both.
Components Clocks, pneumatic tube systems, mail chutes, and incinerators
Components Telephone wiring
Characteristics/Use In small buildings the telephone company supplies the wiring and equipment. Larger
buildings may have extensive systems of built-in cabinets, conduits, and floor ducts for
telephone service. The telephone service in a building may be suitable for the current
occupant but unsuitable for a potential buyer.
Components Fiber-optic cable connections and wireless networks
Characteristics/Use Internet access capabilities for telephone, computer, and cable television
Loading Facilities
Type Open loading docks
Characteristics/Use May be important in commercial and industrial buildings. Off-street loading docks are
usually required by zoning ordinances. Many older buildings have loading doors only or
substandard loading facilities. The floor of an efficient, one-story industrial building may
be built above grade at freight car or truck-bed level.
Type Covered loading docks
Characteristics/Use In some buildings, docks are enclosed for trucks and freight cars, and leveling devices
are provided to assist in loading or unloading. A properly designed industrial building
has space in front of truck docks so that vehicles can maneuver.

Attached Equipment
Components Air hoses
Process piping
Industrial wiring for heavy electrical capacity
Bus ducts
Freezer equipment
Characteristics/Use Often considered in terms of use value.
Intelligent Buildings
An intelligent, or smart, building is designed with automated systems that detect and adjust heating and
cooling equipment in response to changing environmental conditions to increase energy efficiency and
ensure the comfort of occupants. The building may also include centralized control over fire safety, security
access, and telecommunications systems and the use of other technologies that help address the changing
needs of building occupants while controlling costs. These systems are designed to improve end-user security,
control, and accessibility, with the aim of increasing worker productivity and occupant comfort levels.
The occupants of the building often use prominently displayed real-time information about energy costs
(e.g., on an easy-to-read digital control panel) to train themselves to use energy more efficiently in the building.
The commonly accepted definition of a building automation system (BAS) includes the comprehensive
automatic control of one or more major building system functions, such as heating, ventilating, and air-
conditioning systems. Since the 1960s, automation has increased in complexity, from simple systems like
lighting that turns itself on as daylight fades outside and doors that open automatically (first installed in
buildings before 1970) to fire alarm systems that monitor the position of fire and its path within a building
(which appeared after 1980).
More recently, intelligent building design has also included the idea of connecting to a smart grid, an
electricity distribution network based on digital technology that is used to supply electricity to consumers
through two-way digital communication. Smart grids were introduced to overcome the weaknesses of conven-
tional electrical grids by using smart net meters. By connecting to a smart grid and using a demand response
(DR) system, a building can determine automatically through its building management system how much
electricity it needs at various times of day. A DR system manages a building’s consumption of electricity in
response to supply conditions and responds to a utility company’s demand event (such as rolling blackouts)
by automatically reducing the amount of power being used or starting on-site power generation.

Figure 13.4 Commercial Green and Energy Efficient Addendum: Solar Worksheet

Whole Building Approach
For a building to function for its intended use, all the building mechanical systems
(plumbing, HVAC, electrical, etc.) must work together. In traditional building de-
sign, however, these systems are installed and operate separately. Green building has
popularized the “whole building approach” to building design.
The whole building approach is elementary to green building. This approach
views all of a building’s parts as an integrated system. The goal of the whole build-
ing approach is to ensure that the different parts of a building work with, rather than
against, one another. Examples of whole-systems thinking include
• The use of native landscaping to reduce required maintenance (mowing and ir-
rigation) and to preserve and enhance groundwater and wildlife habitat
• “Daylighting” to reduce the need for artificial lighting and energy consumption
and to improve worker comfort and productivity
• Convenient access to public transportation to reduce the amount of space allo-
cated for parking and to foster reductions in vehicle miles traveled (VMT) and
carbon usage
Design Concepts in the Whole Building Approach

front-end loading
An approach to development that includes the examination of site factors, engineering definition, and a
project execution plan before construction. Factors examined in the front-loaded design process include pos-
sible process simplification (value engineering), a constructability review process, customized standards and
specifications, predictive maintenance, and design-to-capacity considerations.
end-use/least-cost considerations
A focus on designing an end product that provides the user with what they actually want and need, at the
least cost to both the owner (or developer) and the environment. (Source: www.rmi.org/buildings)
Teamwork
Collaboration among key professionals is fundamental to planning and designing suc-
cessful green developments, redevelopments, and building retrofits. Appraisers should
be part of the process, providing market and financial analysis. Using the whole
building approach, design is no longer a linear process, with one step taken and then
the next. Also, front-loaded design focuses on up-front solutions with the right team
considering all aspects of the project. Finally, significant savings can be achieved by
thinking through and analyzing how the building will be used and considering how
performance can be optimized before potentially flawed and costly decisions are made.
The whole building approach can have two important, but differing, effects
in the application of the cost approach. The first effect is the potential shift from
operational costs to initial capital costs, and from hard or direct costs to soft costs.
The second important implication is that, due to the synergies achievable with this
approach, the overall cost premium for green building may be reduced or eliminated
through the use of a whole building, integrated design approach. For green buildings
constructed without this approach, the cost may be higher and the function of the
systems may not be optimal relative to a comparable building constructed using a
whole building design approach.

Analysis of Architectural Style and Functional Utility
A building may have functional utility but lack architectural style, such as a multi-
purpose precast concrete warehouse near an interstate interchange, or it may have
admirable style but little utility, such as a cavernous 1920s-vintage movie palace in a
declining urban neighborhood. Form and function work together to create success-
ful architecture. Functional utility is not necessarily exemplified by minimal space or
form. People’s desire for comfort and pleasure must also be considered in the design
of offices, stores, hospitals, and houses. An appraiser must recognize and rank mar-
ket preferences regarding style and functional utility and then relate these preferenc-
es to market value. The ability of improvements to provide utility and the desirability
of specific land uses in the marketplace are the sources of value and the focus of an
appraiser’s investigation of architectural style and functional utility.
Good design meets the following criteria:
• Functions well—fitness of intended use
• Looks good—appeals to aesthetic sense
• Feels good—carries meaning, recreates feeling from another time or place
• Balance—sense of correct proportion, compatibility
• Affordable—consistent with market expectations for price range
• Minimizes adverse impacts on the natural environment, the users of the space,
and the surrounding community
Social and economic issues have the greatest effect on residential design. Govern-
mental issues have a greater effect on nonresidential design through zoning and building
codes. Environmental issues affect the site more than the improvements, although topog-
raphy and other factors may influence the placement of the improvements on the site.
Architectural Style
Architecture is the art and science of building design and construction. Architectural
style affects the market value of property, so an understanding of its nature is impor-
tant to appraisers. Two basic types of styles are distinguished in American architec-
ture: formal architecture and vernacular architecture. Figures 13.5 and 13.6 illustrate
formal and vernacular architectural styles.
Formal architecture refers to the art and science of designing and building struc-
tures that meet the aesthetic and functional criteria of those trained in architectural
history. Formal architectural styles are identified by common attributes of expression
and are frequently named in reference to a geographic region, cultural group, or time
period—e.g., the Italianate, Second Empire, and Prairie School styles.
Figure 13.5 Formal Architecture

Figure 13.6 Vernacular Architecture
To a degree, the distinction between formal and vernacular architecture is analo-

gous to the difference between fine art and folk art. Vernacular architecture identi-
fies structures designed and built without reference to the aesthetic and functional
criteria of architectural history, often buildings with an emphasis on function over
form. Vernacular architecture reflects custom and responds to the environment and
contemporary lifestyles. Vernacular styles share common attributes and may be tech-
nologically simple or sophisticated. These styles are usually unnamed because they
are not formally studied by architectural historians. The traditional barn, the mass-
produced homes constructed in modern subdivisions, and multitenant industrial
park buildings are examples of vernacular styles.
Good architecture is a blend of aesthetics and function. Many historic buildings
are architecturally superior, with great aesthetics but poor functionality for some
uses. A modern vernacular building is more likely to offer better functionality and
poor aesthetics.
Architectural style is influenced by market standards and tastes, which are influ-
enced both by the desire to preserve tradition and by the desire for change, variety, and
efficiency. The market’s desire for change provides the impetus for developing new ele-
ments of architectural design. Changes in architectural trends are caused by the mar-
ket’s reaction to current styles. When a style becomes too extreme, a shift to elements of
past styles frequently occurs. A reactive shift, then, provides contrast to the preceding,
dominant architectural style. These changes also produce avant-garde or experimental
building styles, which are tested in the market and ultimately accepted or discarded.
Changes in architecture can also be generated by external forces. For example, in
the 1970s rising energy costs prompted new developments in the heating, ventilation,
and air-conditioning systems used in office buildings. These developments include
the trend toward stand-alone HVAC systems and the use of new exterior materials
that conserve energy.
Architectural styles
are modified over Literature on American architectural history is abundant and includes
periods that are loosely Virginia Savage McAlester, A Field Guide to American Houses, revised
related to the economic and expanded 2nd ed. (New York: Alfred A. Knopf, 2017) and Carole Rif-
life cycles of buildings. kind, A Field Guide to American Architecture (New York: Dutton, 1980).
Newly constructed build- For a description of architectural styles in a real estate appraisal con-
text, see Judith Reynolds, Historic Properties: Preservation and the Valu-
ings usually contrast in ation Process, 3rd ed. (Chicago: Appraisal Institute, 2006) and Marc P.
style with buildings of Nadeau, Identifying Residential Architectural Styles (Chicago: Appraisal
the previous period. New Institute, 2016). Additional sources are cited in the bibliography.
buildings of all architec-

tural styles enjoy broad market appeal, whether they are professionally designed or
not. When a building is no longer new, however, it is compared with other buildings
in terms of the quality and usefulness of its architectural style. Form and structure,
the most basic components of architectural style, limit and define a building’s poten-
tial uses (and changes in use). These factors become more influential as time passes.
For residential appraisals that require compliance with the Uniform Appraisal
Dataset (UAD) established by Fannie Mae and Freddie Mac, the Uniform Collateral
Data Portal (UCDP) contains a field for architectural design. Ideally, this field would be
filled with the name of a formal architectural style rather than a generic descriptor such
as “two stories” or “typical.” The UCDP compliance check reviews the architectural
design field as if it were required, even though it is not identified as a required field
in the UAD instructions. Properly identifying the architectural style in this field could
improve the efficiency of the review process and avoid a callback for corrections.
Functional Utility
To be functional an item must work and be useful. The definition of functional utility,
however, is subject to changing expectations and standards. Optimal functional util-
ity implies that the design and engineering of a building are considered to best meet
perceived needs at a given time.
Functional inutility is an impairment of the functional capacity of a property or
building according to market tastes and standards. It qualifies as functional obsoles-
cence when ongoing change, caused by technological advances or economic and aes-
thetic trends, renders building layouts and features obsolete to the extent that value
is impaired. (The concept of functional obsolescence is discussed in detail in Chapter
31.) Functional inutility must be judged in light of market standards of acceptability,
specifically the standards of buyers who make up the market for a particular type of
building within a particular period of time. Certain design elements of “smart” office
buildings, such as extra cooling capability, more flexible cabling systems, and ad-
ditional power to run more sophisticated computer systems, may have been super-
adequate when they were originally constructed, but changing market desires have
made some of these items standard.
Standards of functional utility vary with the type and use of property. Specific
considerations for different types of property are discussed in the remainder of this
chapter. Some general standards of functional utility considered by appraisers include
• Compatibility
• Suitability or appropriateness
• Comfort
• Efficiency
• Safety
• Security
• Accessibility
• Ease and cost of maintenance
• Market standards
• Attractiveness
• Economic productivity

Design and Functional Utility by Property Type
Marketability is the ultimate test of functional utility and is a central concern in mar-
ket analysis, as discussed in Chapters 15 and 16. Generally, a building is functional
if it successfully serves the purpose for which it was designed or adapted. Specific
design considerations that affect the functional utility of residential, commercial,
industrial, agricultural, and special-purpose buildings are discussed below.
Residential
Trends in single-unit properties—including single-unit homes, condominiums, coop-
eratives, and rental apartments—change, and building components such as porches,
balconies, roof decks, raised or walk-out basements, fireplaces, dining rooms, large
kitchens, entry halls, and family rooms may be included or excluded. Housing stan-
dards vary widely for different income levels and in different regions. Historic houses
are often less functional, but they may be in great demand due to their historic charac-
ter and architectural appeal. To evaluate the functional utility of residential buildings,
appraisers should identify and analyze standard market expectations. The functional
utility of a single-unit or multifamily dwelling results primarily from its layout, ac-
commodation of specific activities, adequacy, and ease and cost of maintenance.6 In
general, more people have better housing today than they had in the past. Many ame-
nities are now considered necessities and their inclusion is taken for granted. Even in
periods of high construction and financing costs when average houses are smaller, the
tendency is to retain extra bathrooms, labor-saving devices, and fireplaces.
The designs and features desired in the market change all the time and can be
somewhat generational. People of different ages may follow what their contempo-
raries like, and that causes buyers in the same age group to ask for similar features.
Appraisers observe new model homes to identify the design elements and features
currently desired by home buyers when those consumers have a menu of possibilities
to choose from. The design of existing homes may not provide a reliable indication of
current tastes.
In condominium, cooperative, and rental apartment buildings, amenities may be
more important than space. Occupants may prefer a fireplace or an extra bathroom to
an additional 200 square feet of area unless the amount of heated and cooled space is
the single most important factor. Smaller kitchens and bathrooms tend to be more ac-
ceptable in the market for condominiums, cooperatives, and rental apartments than in
the market for single-family houses, but this preference may depend on household size.
A breakfast bar between the living room and kitchen that replaces the formal
dining room is generally acceptable in most apartment markets, but a formal dining
room may be a necessity in the luxury market. Family rooms and living rooms may
be spacious to offset the smallness of other rooms, and plentiful closet space is impor-
tant in many markets.
There is also a trend to convert older commercial and industrial buildings into
apartments. These buildings are often brick or concrete structures with apartments
6. For further discussion of single-unit home design and functional utility, see Henry S. Harrison, Houses—The Illustrated Guide to Construction, Design
& Systems, 3rd ed. (Chicago: Real Estate Education Company, a division of Dearborn Financial, 1998) and Appraising Residential Properties,
4th ed. (Chicago: Appraisal Institute, 2007). The most complete source for information on residential architecture is A Field Guide to American
Houses, 2nd ed., by Virginia Savage McAlster (New York: Alfred A. Knopf, 2013). For discussion of apartment properties, see Arlen C. Mills, Richard
L. Parli, and Anthony Reynolds, The Valuation of Apartment Properties, 2nd ed. (Chicago: Appraisal Institute, 2007) and Daniel J. O’Connell, The
Appraisal of Apartment Buildings (New York: John Wiley & Sons, 1990).

Emerging Trends in Residential Design
Closets: Walk-in closets with built-in drawers and added shelves becoming standard in
bedrooms.
Bathrooms: Multiple fixture bathrooms are standard, particularly in master/owner suites.
Remodeling/renovation: As common as new construction.
Great room: Increasingly important to the functions of the residence; may replace the tradi-
tional living room.
Floors: Wood or simulated wood floors gaining popularity.
Countertops: Granite, quartz, or other solid-surface countertops are the market standard but
other types are growing in popularity.
Windows: Often retrofitted with vinyl coverings on frames for ease of maintenance and
thermo pane for insulation.
Recessed ceiling lights: High ceilings are currently popular despite the energy costs, and recessed light-
ing increases the feeling of space.
Electrical, plumbing, Often replaced with more efficient systems in homes for resale.
and heating systems:
Cabinet finishes: Subject to the whims of fashion.
Doors: Heavy, solid-core doors are replacing standard, hollow-core doors.
Daylight, view-out, and New basement design creates an environment similar to above-grade living
walk-out basements: areas.
Water heaters: Tankless water heaters are replacing traditional multi-gallon tanks.
built into the space, so the configuration of those units may be very different from
apartments that were designed and built from the ground up. In these units, it is
common to see the HVAC ductwork, the conduits for wiring, and other semi-indus-
trial finishes. Some converted units have loft areas built over a low ceiling area and
15-foot ceilings in the living room and kitchen. Converted loft apartments tend to be
a separate residential market.
The layout of a residential property relates to traffic patterns—i.e., where kitch-
ens and bathrooms should be located for convenience and how private and non-
private areas should be separated (see Figure 13.7). A layout has functional inutility if
it causes awkward traffic patterns. For example, inutility may result if people have to
cross the living room to get to a bedroom, if the dining area is not next to the kitchen,
or if groceries have to be brought through the living room to the kitchen.
Standards of adequacy vary. Often, the market will not accept a one-bedroom
house, although one-bedroom apartments and condominium units remain popular.
New kitchens and baths are larger, better equipped, and more expensively finished
than the small, utilitarian kitchens and baths of the recent past. Dishwashers, gar-
bage disposals, and microwave ovens are usually standard in new construction, and
their absence may create a value penalty. Stone, tile, glass panels, or glazed brick in
baths and more elegant fixtures are becoming commonplace. The master bedroom
frequently has its own compartmentalized bath with a spa tub and shower and a
separate dressing area with built-in drawers and shelves. Some examples of function-
al obsolescence in residential property are listed in Figure 13.8. Preferences change,
so there is only one sure thing in residential design: next year will be different from
this year.

Figure 13.7 Residential Layout Considerations
Poor floor plans are easily recognized by those who make up the market for houses, but standards often vary with
current trends in a region and neighborhood. The location of various rooms in relation to the site can increase or
diminish a dwelling’s privacy and comfort.
Single-Unit Homes
• Bedrooms and living rooms are increasingly found in the rear of residences, often accessible to the garden, back-
yard, or deck. Formerly it was considered desirable for the living room and largest bedroom to be at the front of
the house, oriented to the street. The master bedroom is frequently separated from the other bedrooms for privacy.
If the house is multiple stories, the master bedroom may be on the ground level, with additional bedrooms on the
second story. This design may be undesirable to families with small children, however, and could cause functional
obsolescence in some communities.
• Kitchens, which were once relegated to the rear, are now just as likely to be on one side of a hall in the middle or
at the front of a residence.
• Full bathrooms are most convenient, accessible, and private when they are near or attached to the bedrooms. They
should be accessed directly or through a hall, not through another bedroom. Powder rooms should be located off
a hall and near, but not too near, the living room or dining room.
• Below-grade space typically includes additional rooms, such as a recreation room, and additional bedrooms. The
kitchen and living room should be above grade, typically on the ground level. Access to an attached garage should
not be through a bedroom.
Multifamily Units
• Two-story, two-unit residences with vertical access from within the unit, rather than from public space, have strong
market appeal.
• Multiunit housing is also built in stacked configurations with access on more than one level to minimize stair climbing.
• Low-rise, multifamily housing projects can be designed in a great many ways.
• Condominium, cooperative, and rental apartment buildings with elevators tend to have more standardized, predict-
able floor plans to make the best use of space within a simple rectangular configuration.
• Structures designed for other uses are now being converted to residential uses. Silos, breweries, warehouses,
churches, and schools have been successfully converted into single-unit homes and multiunit residential loft projects.
Figure 13.8 Examples of Functional Obsolescence in Residential Improvements

• Interior and exterior finishes that require extensive maintenance can make a structure less competitive.
• In most markets a house that wastes fuel and electricity suffers major functional obsolescence. Energy-conserving
features such as well-insulated windows and efficient heating and cooling systems are particularly important in
multifamily dwellings and often make the difference between a profitable operation and an unprofitable one. Green
building may be the wave of the future for new multifamily dwellings to improve profitability and take advantage
of incentives including special financing for green multifamily buildings.
• The mix of units in an apartment project (e.g., two-bedroom units and three-bedroom units) should meet market
demands. An improper unit mix may indicate functional inutility.
• Not having a master bedroom and master bath when there are two or more bedrooms in the property.
• Insufficient parking. A house with a one-car garage may have functional obsolescence when the surrounding houses
have two-car garages.
• Lack of storage. Today’s building standards require closets in bedrooms. In properties built before World War I,
closets in bedrooms were not typical. Lack of closets is a form of functional obsolescence.

Commercial
Commercial buildings are used for offices, stores, hotels, banks, restaurants, and
service outlets. Frequently, two or more commercial uses are combined in a single
building, e.g., a high-rise office building with ground-level retail space or a hotel
with a retail arcade off the lobby. The structural and design features of commercial
buildings are constantly changing. Developers want the most competitive building
possible, within the cost constraints imposed by economic pressures, so they incorpo-
rate technological changes to meet the demand for innovation whenever practical.
The efficiency of commercial construction today is much greater than it was in
the past. Greater utility can be observed both in the portion of the total area enclosed
by the structure, which produces direct income in the form of rent, and in the struc-
tural improvements that have evolved from new materials and construction meth-
ods. No single method of commercial building construction predominates. Methods
vie with one another, and one may surpass others in a given area at a particular time.
Important considerations of functional utility in commercial properties include
• Column spacing
• Bay depth
• Live-load floor capacity
• Ceiling height
• Module width
• Elevator speed, capacity, number, and safety
• Level of finish
• Energy and water efficiency
• Parking and public transportation (walk score/transit score)
Functional utility can be extremely significant in shopping centers. Trends in shop-
ping centers change so rapidly that many structures become functionally obsolete
before they deteriorate physically. Because retail space is relatively easy to renovate,
many centers are streamlined and modernized when they lose their market appeal.
Some enclosed malls developed in the 1980s have been adapted to other uses or have
been torn down and redeveloped as big-box power centers for value-oriented shop-
pers or lifestyle-oriented centers for high-end consumers. Others have been recon-
figured to include a larger proportion of anchors and junior anchors, and to turn the
store entries outward to the parking lot rather than inward facing a mall.
Many modern community shopping centers are designed with the power center
concept, incorporating a larger number of smaller anchors and a higher ratio of
anchor space to minimize risk. As consumers have migrated toward e-commerce, de-
mand for “brick and mortar” stores has generally declined, creating opportunities to
redevelop older malls, community centers, and neighborhood shopping centers with
multifamily and mixed-used developments.
Visibility and access are primary considerations in the analysis of retail improve-
ments. Other building amenities that can contribute to the functional utility of shop-
ping centers include
• Attractive public areas
• Well-kept grounds
• Adequate, well-located restroom facilities

Emerging Trends in Shopping Center Design
Individuality: Although products are branded to promote consumer loyalty, shopping center
developers are now emphasizing regional differences in architectural style
to avoid homogeneity. Strong brand names within a shopping center are still
desirable, but the shopping center itself should not be seen as a carbon copy of
another property in a chain.
Entertainment retailing: Entertainment functions—movie theaters, restaurants, themed retailers—are
becoming increasingly common in “destination” shopping centers. Research has
yet to demonstrate conclusively that the presence of movie theaters increases
overall sales within a shopping center, but properties that lack entertainment
options may be at a competitive disadvantage in the investment market.
Themed districts within In the past, the tenant mix was often adjusted so that competitors would be in
a shopping center: different areas of a shopping center. To foster convenience, comfort, and control
for consumers with limited time, shopping center owners are starting to cluster
related retailers—e.g., wings of a mall focusing on fashion boutiques, sports-
oriented retailers, goods by price point, and family-oriented stores. The effective-
ness of the tenant mix of a shopping center remains a good indicator of the
competency of leasing and management staff.
New anchors and New shopping centers may be anchored by a big box store or grocery store and
more food: incorporate a food hall with more options and comfortable seating to encourage
customers to visit for more than shopping.
Urban amenities: Some centers emphasize a community experience, with pop-up stores, classes
and activities, more amenities, walkability, and even links to mass transit.
• Suitable traffic patterns for shoppers

• Adequate column spacing
• Sufficient number of escalators and elevators
• Durable and easily maintained surface and finish elements
• Areas for shoppers and workers to rest
• Strong lighting and attractive, coordinated signs
Modern office buildings are often able to fulfill their primary function—accom-
modating the activities of office workers—longer than any other property type, with
the possible exception of residential property. Although trends in office construction
move more slowly than trends in retail and hotel design, the flexibility of office space
is increasingly important to an office building’s viability. Older office buildings that
cannot be retrofitted to contemporary standards for wiring, HVAC capacity, and
other essential systems will suffer in competition with more functional office space.
Office tenants are more likely to pay higher rents for space in an attractively
designed building or for a prestigious address, but tenants are unlikely to renew their
leases if the office space is unable to adapt to their changing needs. Even if a devel-
oper plans to rent full floors of a new office building, there may come a time when
the owner must subdivide floors and rent space to smaller tenants.
Functional considerations for office buildings include
• Appropriate density (low-, medium-, or high-rise structure) for market area
• Building shape and size

Emerging Trends in Office Building Design
Office-hotel concept: As an alternative to negotiating 10- to 20-year office leases, some office building
owners are experimenting with providing short-term or temporary space and services
as needed by tenants.
Panel systems: Panel systems for separating workspaces are replacing traditional methods of
dividing space in offices for several reasons:
1. The cost of the technology needed for the average office worker is rising.
2. More diverse work teams need flexible, adaptable meeting space.
3. Private office spaces can be arranged with new panel systems.
Data and power Raised floors and carpet tile allow greater access to data and power cabling as well
infrastructure: as denser bundling. (Carpet tile helps muffle the hollow sound of raised floors.)
Sufficient space for telecommunications closets is important for long-term flexibility.
Indoor air quality: The Environmental Protection Agency has ranked indoor air pollution among the top
five environmental risks to public health. Poor indoor air quality can be reduced with
proper ventilation and air exchange rates and by using no- and low-VOC products
and finishes in construction.
High density, open-plan Workers choose a work station within “neighborhoods” usually organized by
“free-address” layouts: department.
Amenities included: Areas are provided for food preparation/consumption, indoor and outdoor recreation,
and socializing. Quiet/restorative areas are provided for rest, lactating, and meditating.
Building performance: Measured by the occupants’ productivity, emotional and physical health, satisfac-
tion, and well-being.
• Flexible and efficient use of space (larger floor plates are often desirable but mar-
ket preferences vary)
• Expansion capabilities, including potential vertical expansion (i.e., adding a floor)
• Heating, ventilation, and air-conditioning (HVAC)
• Plumbing, electrical, security, and communications systems
• Floor-to-floor heights
• Facade and interior and exterior signage
• Access to lobbies and public space
• Vertical transportation
• Amenities, e.g., retail and restaurants, fitness centers, day care facilities
• Parking
Access to retail and support services is an important amenity in suburban office
parks because such services may not be within easy driving distance as they are in
urban office districts with a concentration of diverse uses.
Hotels range from tiny inns with fewer than a dozen rooms to huge convention ho-
tels with more than a thousand rooms.7 Hotels and motels were once measured against
standard, current designs. This tendency continues for medium-priced hotels and the
various extended-stay and limited-service categories, but in appraising older facilities
and luxury hotels, variation in architectural styles and interior finish must be considered.
7. For a thorough discussion of hotels, see Stephen Rushmore, John W. O’Neill, and Stephen Rushmore Jr., Hotel Market Analysis and Valuation
(Chicago: Appraisal Institute, 2012) and Stephen Rushmore, Dana Michael Ciraldo, and John Tarras, Hotel Investments Handbook (Boston: Warren,
Gorham & Lamont, 1997).

The physical configuration of a lodging facility is determined by the type of
patrons it serves. A limited service lodging property must be oriented to the needs
of guests who wish to spend a minimum amount of time on the premises. A resort
hotel, on the other hand, must provide a variety of recreational and entertainment
facilities for its guests who will spend a lot of time there.
The amount of hotel space devoted to guest rooms varies. A hotel that is a major
meeting and entertainment center has a much lower proportion of guest rooms to
public areas than an extended-stay hotel. Many extended-stay hotels consist entirely
of suites with small equipped kitchens, living rooms, and separate bedrooms. These
hotels usually have small lobbies and limited food service facilities. Because fewer
hotels contain just guest rooms, appraisers must often consider multiple, mixed uses
when analyzing the functional utility of the improvements.
Emerging Trends in Hotel Design

Needs of the business Access to communications technology (high-speed internet connectivity in all
traveler: areas of the hotel, smart speakers such as Alexa, charging stations, in-room
printers, and video communication devices) is increasingly important to business
travelers.
Product types: Full-service, select service, all-suite, extended-stay, convention, and resort hotels
are still popular lodging concepts. More recently, boutique hotels have gained
in popularity, offering unique, stylish accommodations and consistent service
standards. Large lodging chains have developed their own boutique hotels to
attract guests looking for a modern, stylish experience. With the rise of col-
laborative work space, new hotels are incorporating larger lobbies for co-working
and socializing areas. Another trend, particularly for limited service hotels, is to
provide breakfast for all guests. This can be as simple as a continental breakfast
or as elaborate as a full American breakfast.
Industrial
The most flexible design for industrial buildings, and the one with the greatest ap-
peal on the open market, is a one-story, square or nearly square structure that com-
plies with all local building codes. Even for the simplest industrial buildings, though,
the factors listed in Table 13.2 must be considered.
The combination of old and new industrial space may create substantial func-
tional obsolescence if the new construction contributes less than its cost to the value
of the whole. The layout of industrial space should allow operations to be carried out
with maximum efficiency. Typically, receiving functions are performed on one side of
the building, shipping functions on the other, and processing or storage functions in
the middle.
Some industrial buildings include special features such as sprinkler systems,
scales, loading dock levelers, cranes and craneways, refrigeration areas, conveyor
systems, process piping (for compressed air, water, and gas), power wiring, and
employee lockers and lunchrooms. These features may be standard equipment for
certain industrial operations but not standard for the local real estate market.
Manufacturing plants and other buildings used for industries that involve bulky
or volatile materials and products have specialized equipment and building designs, so
they have few potential users. Facilities for industries such as food processing or manu-

Table 13.2 Functional Utility of Industrial Improvements
Surplus land* In new construction surplus land on the site is frequently allocated for future
expansion.
Clear span Anywhere from 21 to 35 feet. Many smaller warehouses can be operated with
a clear span of 12 to 20 feet or more, but higher ceilings may be standard
in the market.
Percentage of office space Varies widely depending on specific operation. If potential alternate uses of
an existing property do not require as much finished office space, the excess
may be an overimprovement.
Loading facilities Multiple load facilities can reduce delays in incoming deliveries and outgoing
orders. Overhead doors are less efficient loading facilities than loading docks,
dock-high floors, and truck wells. Rail sidings are common for certain types
of industrial properties.
Floor thickness and loading capacity Typically, 5 to 8 inches of reinforced concrete. Live-load capacity—the ability
to support moving or movable objects in the building at a certain weight—is a
minimum 125 pounds per square foot for light warehouse space and manu-
facturing buildings and 250 pounds per square foot for heavy warehouses.
Power service Manufacturing plants generally require more electrical service than warehouses.
Insulation and climate control Warm climates may dictate cool (white) roofs and ceiling insulation and, in
some cases, HVAC to maintain stable interior temperatures.
Fire sprinklers Wet or dry fire suppression systems may not have been required when older
structures were built, but may now be the norm in the market or required for
certain types of uses.
Land-to-building ratio or floor area ratio Typically, a ratio of land area-to-building area of 2.5 to 3.5. Many older facili-
ties have ratios from 1.3 to 2.5. The land-to-building ratio must allow plenty
of space for parking, truck maneuvering, yard storage, and expansion. Floor
area ratio (FAR) is also known as building-to-land ratio.
Size relative to typical building size Big-box warehouses can be significantly larger than competitive buildings in
the market.
The cost of reconfiguring a large industrial building for multitenant use is a
measure of functional inutility.
Slope of access to the site Steep inclines can reduce loading efficiency.
* See the discussion of excess land and surplus land in Chapter 12.
facturing computer chips must maintain prescribed levels of cleanliness. For example,
the “clean rooms” needed for silicon wafer production may not contribute as much value
as they cost to construct if used for alternative industrial uses. Buildings used for light
manufacturing and processing have fewer limitations and broader appeal in the market.
Storage and distribution facilities range from simple cubicles, known as mini-
warehouses, to huge regional warehouses with more than a million square feet. For
optimal functional utility, warehouses should have adequate access, open areas,
ceiling height, floor load capacity, humidity and temperature controls, shipping and
receiving facilities, fire protection, and protection from the elements.
The primary consideration in a warehouse’s location is good access. Just-in-time
inventory practices require a distribution facility to be accessible to a greater variety of
vehicles and cargo containers, making more frequent and often smaller pick-ups and
deliveries. As a result, docks and dock areas must be designed with greater flexibility.
Trucking is the most common means of transporting goods, but certain warehouse
operations also need access to rail, water, and air transportation. If electric trucks are

used, a battery-charging area should be included. In the future, the use of “driverless”
trucks may have a significant impact on trucking and industrial uses of property.
Forklifts, conveyor belts, and automatically guided vehicle conveyor systems are
used to move materials inside warehouses. Pallets, or portable platforms, are used
for moving and storing materials in most distribution operations. Therefore, ceil-
ing heights in warehouses should accommodate the stacking of an ideal number of
pallets. Newly constructed high-cube warehouses may be more efficient than older
buildings with larger footprints and fewer automated systems for moving materials.
Because wide spans provide maximum flexibility, a square structure generally is the
most cost-effective.
Sprinkler systems are needed in most warehouses, especially those where flam-
mable goods are stored. The nature of the stored material determines whether the
system should be wet or dry, using water or chemicals.
Emerging Trends in Industrial Building Design

Automation: Industrial operations are less labor-intensive and more equipment-intensive than
they once were, and the buildings that house these operations can devote more
space to machinery and systems than to break rooms, locker rooms, etc. For
example, telecom hotels, internet switching centers, and data centers often consist
of bare storage space for computer equipment and are rarely visited by the people
who own the equipment. Also, automated inventory operations increase efficiency,
particularly when dealing with small electronic components or other products that
are difficult to distinguish by the naked eye.
Just-in-time Manufacturers do not want to be burdened with the cost of storing large
manufacturing and quantities of the products they produce, so their suppliers—and the
inventory practices: warehouse operators who serve them—focus less on the long-term storage
of inventory and more on the movement of inventory.
Buildings on Agricultural Properties

As the small, family farm has given way to fewer, larger farms, the contribution of
farm buildings to the total value of farm real estate has been steadily decreasing. The
number of farm buildings per acre of farmland has also decreased. Farms are increas-
ingly operated by large, specialized business concerns, and the equipment and man-
agement needed to run agricultural operations have become increasingly specialized.8
Farm buildings must accommodate the type of machinery and equipment cur-
rently used in farming (see Table 13.3). To be useful, each farm building must contrib-
ute to the operating efficiency of the entire farm. Each building’s usefulness relates
to the type and size of the farm. Functional obsolescence can result from having too
many farm buildings when fewer would be more efficient.
Special-purpose Buildings
Although most buildings can be converted to other uses, the conversion of special-
purpose buildings generally involves extra expense and design expertise. This
conversion process may not be economically feasible or practical in many situations
8. For additional information on improvements to rural land, see Rural Property Valuation (Chicago: Appraisal Institute, 2017).

Table 13.3 Characteristics of Improvements on Agricultural Land
Type of Building Characteristics
Barns • Some barns have traditionally been multifunctional, providing animal shelter, grain
storage, and a threshing floor. Other structures, such as tobacco barns and modern
farm buildings, serve a single, specialized purpose.
• Most barns are built of wood or metal, but some are made of stone, logs, or brick,
depending on the region.
• Old barns are suitable for modern, general-purpose farming if they are sufficiently
adaptable. Virtually all newer barns have pre-engineered pole construction, which is
less expensive and can accommodate more farming activities than older, multistory
barns can.
Silos • Silos have become more prevalent and larger. The use of baled, rather than loose,
hay and the increased use of ensilage have lessened the need for barn storage.
Animal shelters • Animal shelters should be dry and clean, provide protection from the wind and sun,
and be adaptable to equipment storage.
Machine sheds • Sheds are needed to house tractors, combines, discs, plows, harrows, cultivators,
pickers, trucks, and other equipment.
Shop • Most farms have an area for maintenance of mechanical equipment. Often the shop
is a pole barn or prefab metal building with concrete floors that has been modified.
In winter, this may be the most important building on the property.
• Usually heated, cooled, and insulated.
Dairy production facilities • Modern dairy facilities are built using concrete tilt-up, concrete block, or metal prefab
construction. Double parallel and rotary milk stalls are standard. Old flat barns and
herringbone style stalls are still in use but are being phased out.
depending on a building’s design and special construction features. Special-purpose

structures include
• Houses of worship
• Theaters
• Greenhouses
• Schools
• Rail and transportation facilities
• Sports arenas
• Other specially designed and constructed buildings
The functional utility of a special-purpose building depends on whether or not the
building conforms to competitive standards. For example, the design of movie theaters
has changed over time due to high maintenance and utility costs. Older, ornate movie
theaters still exist, but newly constructed theaters are generally simple, unembellished,
functional structures containing a larger number of smaller screens with stadium-style
seating. In the vast majority of markets, large and ornate theaters are not being built.
The design and materials used in houses of worship are simpler today to keep
maintenance and utility costs down. The functional utility of these structures, like
sports and concert arenas, is primarily related to seating capacity. The structure’s
support facilities, general attractiveness, and appeal must also be considered.9
9. For more information on houses of worship, see Martin H. Aaron and John H. Wright Jr., The Appraisal of Religious Facilities (Chicago: Appraisal
Institute, 1997).

Evaluating Functional Utility in Special-purpose Buildings
To investigate the functional utility and value of building components designed specifically to serve the use of
a special-purpose property, appraisers can employ several strategies:
• Review appraisal literature pertaining to properties in a similar product category
• Search for market data on similar—i.e., not directly comparable—or related facilities
• Interview the current or recent occupant and other operators in that particular field
• Interview brokers or other appraisers specializing in that product or with experience in that segment of the
market
• Interview the project architects and engineers
• Review building plans with a cost estimator or with architects or engineers experienced in that product type
• Review taxation case studies for pertinent precedents
Appraisers should also analyze the Competency Rule of the Uniform Standards of Professional Appraisal
Practice in assignments relating to special-purpose property.
Source: David Paul Rothermich, “Special-Design Properties: Identifying the ‘Market’ in Market Value,” The Appraisal Journal (October 1998): 410-415.
The adaptive-use movement has generated public interest in the conversion of

special-purpose buildings to preserve architecturally significant structures that have
outlived their function. Railroad stations, schools, firehouses, and grist mills are
popular structures for conversion. The functional utility of these buildings relates
to how much they deviate from building codes and how the cost of rehabilitation
compares with the potential economic return. A typical item of functional inutility in
adaptive-use projects is an insufficient number of staircases to meet building codes.
By contrast, a high ceiling in a specialty property does not indicate functional inutili-
ty if it is considered a desirable architectural feature. Compliance with the Americans
with Disabilities Act is an additional consideration in evaluating the adaptive use of
older buildings.
Mixed-use Buildings
Many buildings successfully combine two or more revenue-producing uses:
• Residential units are often found above ground-floor retail space.
• Research and development facilities often combine office, laboratory, and indus-
trial space within a single structure.
• Office buildings often contain ground-level retail space and restaurants.
• Hotels can be combined with retail, office, or residential uses.
In mixed-use buildings, each type of use reflects a number of design criteria, which
must be analyzed separately. The structure must also be considered as a whole to
determine how successfully it combines uses. The uses that are combined should be
compatible, but minor incompatibilities can be alleviated with separate entrances, el-
evators, and equipment. In a mixed-use building without separate entrances and eleva-
tors, for example, the residential units on upper floors and the office units below would
both suffer. Only in a rather large building can the extra expense of separate features
be justified. A hotel located in an office building should have its own entrance and
elevators. Security and privacy should characterize a building’s residential area, while
a professional, prestigious image is desirable for the office portion of the structure.

Mixed-use developments (MUDs) are characterized by the physical and function-
al integration of their components. They are often sprawling structures built around
centrally located shopping galleries or hotel courtyards. Walkways, plazas, escala-
tors, and elevators provide an interconnecting pedestrian thoroughfare with easy
access to parking facilities located underground, at street level, or above-ground.
Because mixed-use developments bring together diverse participants, they require
extensive, extraordinarily coherent planning.
Quality and Condition Survey

The building description and analysis of architectural style and functional utility cul-
minate in the quality and condition survey. A structure can have a functional layout
and an attractive design but be built with inferior materials and poor workmanship.
These deficiencies increase maintenance and utility costs and adversely affect the
property’s marketability. Conversely, a building can be built too well or at a cost that
cannot be justified by its utility. Most purchasers will not pay for these excess costs,
and only part of the original investment can be recaptured by the original owner
through reduced maintenance expenses.
Practical or reasonable economy of construction results in an improvement that
will produce rental income or value commensurate with its cost. Maintenance and
operating expenses for an economically constructed building may be slightly higher
than minimum expenses, but it is usually better to pay those expenses than to invest
in a building of superior construction that will have higher taxes. This tradeoff may
be noted in an appraiser’s analysis. To achieve the desired level of construction qual-
ity and cost, building materials and construction methods must be chosen and used
properly. An appropriate combination of elements results in a building that is ad-
equate for its intended purpose.
The character, quality, and appearance of building construction are reflected
in each of the three approaches to value. The quality and condition of building
components greatly influence the cost estimate, the depreciation estimate, the
ability of the property to produce rental income, and the property’s comparability
with other properties. Analysis of the quality of construction and the methods and
materials used complements an appraiser’s analysis of the building’s structural
design and architecture.
When a contractor takes shortcuts and fails to meet the advertised or contracted
quality level of new construction, property owners and lenders can find themselves
embroiled in litigation with aggrieved occupants. Because of the growing complex-
ity of building design and construction, the quality of building components and
construction is often best judged by a consulting engineer. The engineer can monitor
the construction process
to ensure that the work
In the condition component of a quality and condition survey, conforms to approved
appraisers distinguish among items in need of immediate repair (de- drawings and that the
ferred maintenance items), short-lived items that can be replaced at workmanship is satis-
a later date, and long-lived items expected to last for the remaining
economic life of the building. Researching incentives and rebates at factory. An experienced
www.dsireusa.org may provide resources for reducing the cost to cure appraiser may be able to
for all types of property components. relate evidence of con-
struction problems—sag-

ging floors, leaks, drafts, etc.—gathered in the property inspection to materials of
poor quality or shoddy workmanship.
In the condition component of a quality and condition survey, appraisers gener-
ally distinguish among two types of building components:
1. Items that may be repaired or replaced at a later time (i.e., short-lived items with
remaining useful lives)
2. Items that are expected to last the full economic life of the building (i.e., long-
lived items)
Examples of each type of building component are shown in Figure 13.9.
Short-lived Items
During the building inspection, an appraiser usually short-lived item
encounters items that show signs of wear and tear but A building component with
would not be economical to repair or replace on the an expected remaining
economic life that is shorter
date of the appraisal. The economic life of a building
than the remaining economic
is the period over which the improvements contribute life of the entire structure.
to property value. Many building components have to
be repaired at some time during the economic life of
the building. If the remaining life of the component is
shorter than the remaining economic life of the structure as a whole, the component
is identified as a short-lived item. (Age-life concepts such as economic life and remain-
ing economic life are discussed in more detail in Chapter 31.)
An appraiser must decide if an item needs immediate repair or replacement or
whether this work can be done later. If the repair or replacement will add less to the
value of the property than it will cost, the maintenance should usually be delayed.
For example, a building with a sound, 10-year-old roof may hold up well for at least
another five years. Although the roof has suffered some deterioration, replacing it
probably would not add more value to the property than the cost of a new roof.
An appraiser should consider whether repairing an item is necessary to preserve
other components. For example, sometimes the roof cover must be replaced or the
economic life of the other components will be reduced. The appraiser should note
whether the condition of the short-lived item is better or worse than the overall con-
dition of the building.
Long-lived Items long-lived item

The final step in a quality and condition survey is to de- A building component or site
scribe the condition of those items that are not expected improvement expected to
to require repair or replacement during the economic have the same useful life as
the entire structure.
life of the building, assuming they are not subject to ab-
normal wear and tear or accidental damage. A building
component with an expected economic life that is the
same as the remaining economic life of the structure is called a long-lived item. Repair
may not be required because the component has been built to last and has been well
maintained. All the long-lived components of a building are rarely in the same condi-
tion. The items that are not in the same condition as the rest of the building are the
important ones in the appraisal analysis.

Figure 13.9 Sample Items Considered in the Quality and Condition Survey
Deferred Maintenance Items
• Touch-up exterior paint needed
• Minor carpentry repairs on stairs, molding, trim, floors, and porches
• Redecorating interior rooms
• Fixing leaky or noisy plumbing
• Loosening stuck doors and windows
• Repairing torn screens and broken windows
• Rehanging loose or damaged gutters and leaders
• Replacing missing shingles, tiles, and slates and repairing leaky roofs
• Fixing cracked sidewalks, driveways, and parking areas
• Doing minor electrical repairs
• Replacing rotten floor boards
• Exterminating vermin
• Fixing cracked or loose tiles in bathrooms and kitchens
• Repairing septic systems
• Eliminating safety hazards such as windows that have been nailed shut
• Eliminating fire hazards such as paint-soaked rags in a storage area
Short-lived Items
• Interior paint and wallpaper
• Exterior paint
• Floor finishes
• Shades, screens, and blinds (often considered personal property)
• Waterproofing and weatherstripping
• Gutters and leaders
• Roof covering and flashing
• Water heater
• Furnace
• Air-conditioning equipment
• Carpeting
• Kitchen appliances (considered short-lived items only if built-in)
• Sump pump
• Water softener system (often rented, not owned)
• Washers and dryers (often considered personal property)
• Ventilating fans
Long-lived Items
• Hot and cold water pipes
• Plumbing fixtures
• Electric service connection
• Electric wiring
• Electric fixtures
• Ducts and radiators
• Walls, foundation, roof structure

Some defective long-lived items are not considered in need of repair because the
cost of their replacement or repair is greater than the amount these items contribute
to the value of the property. A serious crack in a foundation wall, for example, would
probably be considered incurable physical deterioration. Incurable depreciation that
results from problems in the original design of a structure is considered incurable
functional obsolescence.
Green Building Documentation

In valuation analyses of sustainable, high-performance green properties, appraisers may want to incorporate
the following types of documentation:
• Third-party certifications and ratings and accompanying reports (e.g., LEED, EPA’s National Energy Perfor-
mance Rating, and ENERGY STAR)
• Modeled operating data for proposed buildings (e.g., DOE energy models, USGBC water models, lighting
models, transportation demand studies)
• Commissioning reports
• Post-occupancy evaluations (POEs) for properties at least one year old
• Indoor air quality assessments
• Technical specifications of systems in existing or proposed buildings (e.g., narrative, construction drawings,
engineering reports) demonstrating their benefits (e.g., natural ventilation system or interior vegetation)
• Estimates from cost estimators based on these technical specifications showing cost differentials relative
to standard systems
• Site evaluations providing an assessment of ecosystem health, functionality, and the provision of ecosys-
tem services
• Lease agreements and other documents demonstrating specific income adjustments based on environ-
mental or social costs and benefits (e.g., a proposed building may qualify for storm water fee reductions
based on meeting certain criteria)
• Documented incentives, which may include tax abatements that will affect the net income analysis. Cur-
rent incentives for building green can be found at a national website (www.dsireusa.org). These incentives
may offset the additional cost to build green.

Statistical Analysis in 14
Appraisal
In the valuation process, data analysis naturally follows the various data collection
activities discussed in the previous section of this book. A variety of analyses inform
an appraiser’s conclusions about value: market analysis, highest and best use analy-
sis, and the application of the approaches to value. Each of those forms of analysis
deals directly with different sets of data about the subject property, competitive prop-
erties, and the larger market. However, all of those traditional appraisal analyses are
increasingly influenced by the discipline of statistics.
Computer technology and data availability have made statistical analysis increas-
ingly usable and appropriate for real estate professionals. Statistical analysis provides
the tools to take advantage of large amounts of data. Mortgage lenders use statistical
analysis extensively, and tax assessors frequently use statistical models.
In today’s world of abundant data, reliance on direct appraisal experience in
place of looking for facts from data to support conclusions is outmoded. Although
the study of data has always been at the core of the
valuation process, the availability of tools for more
rigorous analysis and interpretation of numerical data statistics
has raised expectations for more “statistical” support A body of principles and
for value conclusions. As a result, a more formal under- methods concerned with
extracting useful information
standing of basic statistical terminology and techniques from numerical data.
has become a prerequisite for professional compe- statistical analysis
tency. Statistical techniques like regression analysis Quantitative techniques
have become accepted tools in the application of the used, for example, to
approaches to value. In fact, the application of regres- estimate value and identify
sion analysis to comparable sales data is a natural and and measure adjustments to
obvious extension of the traditional analysis of differ- the sale prices of compa-
rable properties; techniques
ences in the sale prices of comparable properties in the include statistical inference
adjustment process. A simple linear regression model and linear and multiple
can be used to estimate the influence of a particular regression analyses.
characteristic with significant statistical reliability when
an adequate supply of data is available. Historically,
descriptive statistics assessors have used similar statistical techniques as
A branch of statistics con- part of the mass appraisal of large pools of proper-
cerned only with character-
izing, or describing, a set of ties. For years traditional appraisal techniques have
numbers. The measures used been steeped in statistical analysis, even if the formal
to characterize a set of data vocabulary of statistics has not always been used to
(e.g., average, maximum, describe the application of statistical techniques in the
coefficient of dispersion) or context of appraisal.
charts and tables depicting
the data. Statistical applications are generally divided into
inferential statistics two types—descriptive statistics and inferential sta-
The process of drawing tistics. The category of descriptive statistics includes
conclusions about popula- summary measures, charts, and tables used to describe
tion characteristics through a sample or population. Inferential statistics involves
analysis of sample data. the use of sample data to support opinions (i.e., infer-
ences) concerning a population represented by the
sample. Statistical inferences can include, among other
things, estimates of actual but unknown population
central tendency and dispersion, outcome predictions, and the underlying structure
of cause-and-effect relationships.
The effective use of descriptive statistical tools such as tables, charts, and graphs
is an important skill. Appraisal reports that include relevant, helpful data visualiza-
tions are often easier for the intended users to read and are perceived as more cred-
ible. (The effective use of tables, charts, and other illustrations in appraisal reports is
discussed in Chapter 33.) The competent use of inferential statistical analysis is more
complicated, generally requiring study of a separate body of knowledge. Because the
field of statistics is a discipline unto itself, appraisers should identify the extent to
which statistical methods will be used in their practices and determine the education
and training they will need to be able to accurately use statistics to provide credible
appraisal services. This chapter introduces the foundational terms and concepts of
statistics and describes the use of statistical analysis in appraisal.1
What Is Data?
In the valuation process, data is classified in terms of its use in the appraisal, i.e.,
general data, specific data, or competitive supply and demand data as discussed in
Chapter 9. In the broader context of statistics, data is any set of facts such as numbers,
measurements, or terms. Applying the statistical sense of the word to the activities of
real estate appraisers, data is simply unprocessed observations and descriptions about
real property and the markets in which real property is bought and sold. These raw ob-
servations and descriptions fall into two general categories: (1) qualitative data, which
is descriptive in nature, and (2) quantitative data, which has to do with numbers.
Every appraisal assignment begins with the receipt of raw data from a client in
the form of an address, legal description, parcel number, or other narratively descrip-
1. Appendix B , which is available online at www.appraisalinstitute.org/15th-edition-appendices/, discusses more complex concepts and consider-
ations in the use of statistical applications like multiple regression analysis. In the professional appraisal literature, much has been written about
statistical tools and how they relate to appraisal, and this material is readily accessible in publications such as The Appraisal Journal. See, for
example, a series of three articles by Bryan L. Goddard in The Appraisal Journal: “Graphics Improve the Analysis of Income Data” (October 2000):
388-394; “The Power of Computer Graphics for Comparative Analysis” (April 2000): 134-141; and “The Role of Graphic Analysis in Appraisals”
(October 1999): 429-435. See also the regular “Cool Tools” and “Maps & Comps” columns in Valuation magazine.

tive information that identifies the subject property.
This type of data is referred to as qualitative data. Ad- qualitative data
dresses and parcel numbers contain numbers, but that Data that is based on
subjective measures, where
data does not serve a quantitative function. In contrast, the data tends to fall into
quantitative data is numerical information, such as the nominal or ordinal catego-
square footage of the improvements, the lot size, the ries; usually represented
age of the property, or the number of listings in the in the form of words. For
relevant market area. example, a characteristic
like curb appeal may indeed
Qualitative data can also be separated into two cat- affect market value but
egories: (1) discrete data, which is data that will always may be difficult to quantify
have a specific value and for which there are a finite numerically. Also referred to
number of possible values (e.g., the number of pending as categorical data.
sales in a given zip code or the number of rental units quantitative data
in an apartment building), and (2) continuous data, Variables that can be objec-
which is basically all other numerical data. Continuous tively measured or counted
and expressed in numerical
data is usually associated with some sort of physical form. For example, square
measurement (e.g., the square footage of a building or footage, length, age, number
its remaining economic life). of rooms, and ceiling height
are all quantitative variables.
Levels of Data
There are generally four levels of data measurement or
data classification:
1. Nominal
2. Ordinal
3. Interval
4. Ratio
Nominal level data is data that does not have any standard means of order.
Nominal data is distinguished only by its name. For example, architectural style is
a type of qualitative data that does not lend itself to ranking or order. A Tudor style
house cannot be correctly or incorrectly placed in a list above or below a Victorian,
colonial, or brownstone. Simply put, there is no right or wrong way to order a list of
architectural styles.
Ordinal level data is also distinguished by name but differs from nominal data
because it can fall into an ordering scheme. For example, the condition ratings in
the Uniform Appraisal Dataset, C1 to C6, are a series of data that follows a specific,
meaningful order. Similarly, a more traditional set of condition ratings might flow
from poor to excellent. While there are differences between the rankings (that is, fair is
better than poor), the rankings alone do not indicate a finite measurement that can be
applied to identify that difference.
Interval level data is similar to ordinal level data because it also has a specific
ordering scheme, but interval data is distinguished from ordinal data in that the dif-
ference between one data point and the next is measurable. However, interval data
does lack a zero starting point or a baseline. For example, a review of historic sales
data might call for a measurement of price changes during the period of, say, 2012 to
2017. Although 2017 is clearly five years after 2012 (i.e., the difference is measurable),
there is no absolute beginning year prior to which analysis can no longer take place.
Statistical Analysis in Appraisal 251

The final level of data is ratio level data, which is just like interval level data
except that ratios now make sense. For example, an appraiser might be asked to
determine the rentable area for a suite in an office building. Suppose the building has
100,000 square feet of gross rentable area, the total amount of common area in the
building is 10,000 square feet, and the usable area of the office suite is 18,000 square
feet. First, this data can be ordered:
10,000 < 18,000 < 100,000
The differences between the data values are also meaningful. Ratios of the various
area amounts can be calculated because there is a base point of zero below which
there is no building at all:
Gross Rentable Area =
Rentable/Usable Ratio = 100,000 = 1.11
Usable Area 90,000
Load Factor (Load) = Rentable/Usable Ratio - 1 = 1.11 - 1 = 0.11%
Usable Area × Rentable/Usable Ratio = Rentable Area = 18,000 × 1.11 = 20,000
Rentable Area = Usable Area = 20,000 = 18,000
Rentable/Usable Ratio 1.11
Figures are rounded.
In this case, the rentable area calculated from the supplied data is 20,000 square feet.
Populations and Samples

Pools of data of all levels can be arranged into various sets and subsets. At the broadest
end of the spectrum, a population consists of all of the items under consideration, such
as all of the rental units located in garden-level apartment developments in a given
market area. A parameter is a factually known or determinable summary measure that
describes a characteristic of a population (i.e., a variable). The mean size of all of the
units in garden-level apartment developments in a given market area is an example of
a parameter. (Size is the variable and the population mean is the parameter.) In con-
trast, a sample is a subset of a population that has been selected for analysis. A statistic is
a summary measure derived from sample data. The mean size of all of the apartment
units in a sample selected from garden-level apartment
developments in a given market area is an example of
a statistic. Sample statistics are used to estimate popu-
sample
lation parameters. That is, population parameters are
In statistics, a subset of
a population selected for inferred through the analysis of sample statistics.
analysis. As stated earlier, descriptive statistics is concerned
parameter with data collection, presentation, and quantification.
1. A constant or value used For example, the descriptive statistics on a sample
to index a function, such might include the sample size, the collection method,
as use of degrees of and the date. Descriptive statistics might also include
freedom to derive an numerically quantifying the dispersion and central ten-
appropriate t-statistic or
F-statistic function. dencies of the sample variables by reporting minimum
2. A number that describes and maximum values, ranges, quartiles, standard devia-
a characteristic of a tions, means, medians, or modes. Specific examples
population. of descriptive charts, graphs, and tables include histo-
grams, pie charts, bar charts, line graphs, scatter plots,

ordered arrays, relative frequency distributions, and percentage distributions. De-
scriptive statistical methods are applicable to population data as well as sample data.
Fundamentally, inferential statistics involves estimating a population parameter
using sample data or reaching a conclusion concerning one or more populations
based on sample data. For example, the National Association of Realtors (NAR)
publishes monthly median home price statistics for various markets throughout the
United States. (See Figure 14.1.) Changes in the price level of the underlying popula-
tion of homes are generally inferred from this sample statistic. The reliability and
validity of this inference—i.e., how accurate the inference is—depend on a number of
factors including sample size and how well the sample represents the population.
Figure 14.1 Sample Data from the National Association of Realtors
Copyright ©2019 “Median Price of Existing Home Sales.” NATIONAL ASSOCIATION OF REALTORS®. All rights reserved. Reprinted with permission. July
12, 2019, https://www.nar.realtor/sites/default/files/documents/ehs-05-2019-summary-2019-06-21.pdf
A measure of accuracy (e.g. margin of error) is usually reported along with an in-
ference. The measure of accuracy states the degree of uncertainty associated with the
inference. For example, polling data usually includes an inference and its associated
margin of error, which describes a confidence interval at some preselected confidence
level (generally 90%, 95%, or occasionally 99%).
Uncertainty cannot, however, be quantified when the sample is a nonprobability
sample. (With a nonprobability sample, the probability of any given sample item
being chosen from the underlying population is unknown. Examples of nonprobabil-
ity samples include convenience samples, intact groups, and self-selection.) Median
home price statistics reported by NAR are derived from nonprobability samples, so a
degree of uncertainty is not reported and cannot be calculated due to the manner in
which the data is collected.

These terms and concepts are important in all types of real estate appraisals. To
provide meaningful and credible results, appropriate terminology and concepts must be
used. When appraisers gather comparable sales, they should recognize that only some
of the properties in the population of which the sales are a part will have sold in a given
time period. Thus, the sales may or may not represent that population and would not
constitute a random or unbiased sample. To report that “the mean sale price of the prop-
erties sold in the subject property’s market area between 2017 and 2018 was $175,000”
would be more accurate than “the average price for properties in the neighborhood in
2017 was $175,000.” The latter statement implies that all properties were sold.
Measures of Central Tendency

Central tendency refers to a typical value that describes a sample or population vari-
able. The three most frequently used measures of central tendency are the median,
mean, and mode. The widely accepted definitions of market value all use language
that relates to the measures of central tendency (e.g., the “most probable price” is the
mode, the “expected price” is the median or mean).
Median
The median is the middle value in an ordered array—i.e., a data set arranged nu-
merically from lowest to highest or highest to lowest. The median is unaffected by
extreme values in sample data. As a result, it is often reported when one or more
extreme values distort the ability of the mean to accurately depict central tendency.
If a data set contains an odd number of observations, the median value is the
observation at the (n + 1)/2 position in the ordered array, where n is the sample size.
If the data set has an even number of observations, then the median is the value
halfway between the two middle observation values. For example, if the data set
has 15 observations, the median is the eighth data point in an ordered array of the
data. If the data set contains 14 observations, then the median would be the midpoint
between the seventh and eighth data points in the ordered array.
Measure Location
median
A measure of central tendency identified as the middle value in an (n + 1)/2 ordered observation
ordered array of numerical values, e.g., 7 is the median of (1, 4, 6, 6, 7, 9, where
11, 22, 41). If the ordered array contains an even number of values, then n = odd-numbered sample size
the median is the mean of the two values on either side of the middle.
mean of (n/2) and (n + 1)/2
ordered observations
where
n = even-numbered sample
size
Arithmetic Mean
The arithmetic mean is the most commonly reported measure of central tendency.
It is often referred to as the sample mean, or population mean, or simply as the mean.
Sample mean is represented by the symbol x. Population mean is symbolized as the

Greek letter µ (“mew”). The sample mean is calculated by summing the values of all
observations on a variable and dividing the sum by the sample size (n). Similarly, the
population mean is calculated by summing the values of all items in a population
and dividing by the population size (N). Because the arithmetic mean includes all ob-
servations on a variable, its calculation is affected by any extreme values, which may
distort its depiction of central tendency. When this occurs, the population mean is not
the best representation of central tendency.
The mean is very amenable to statistical inference when the population distribu-
tion is known or can be reliably approximated or when the sample is large enough.
The Student’s t distribution (also known as simply the t-test) is the most frequently
used measure to assess the degree of uncertainty associated with statistical inferences
of the true population mean parameter based on the sample mean.
Measure Calculation
mean
A measure of central tendency. The sum of values for a variable in a Sample Mean (x)
n
sample or population divided by the number of items in the sample or S xi
population. The arithmetic average. i =1
x = n
where
n = sample size
Population
N
Mean (m)
S xi
m = i =1
N
where
N = population size
Geometric Mean
Central tendency for compound financial returns over time can be measured by the
geometric mean. The geometric mean is an important financial concept.
Measure Calculation
geometric mean
The nth root of the product of n items. A geometric mean represents the x = [x1 × x2 × … × xn ]1/n
central tendency rate of change for a phenomenon that grows in a com- where
pound fashion over time, such as many financial returns. n = number of compounding
periods
Mode
The mode is the most frequently occurring observation in a sample data set. It is not
affected by extreme values, but it is more variable from sample to sample. If more
than one mode occurs, the data set is multimodal. For example, a data set with two
modes is referred to as bimodal. The mode is undefined for some data distributions

(e.g., the uniform distribution), and, unlike the mean and median, there are no statis-
tical tools useful for making inferences based on the mode.
Measure Location
mode
A measure of central tendency consisting of the numerical value or Most frequently occurring
categorial characteristic that occurs most frequently in a sample or observation in a data set.
population. For example, the mode of a data set (2, 4, 5, 6, 6, 7, 7, 8, 8,
8, 8, 10, 12) is 8, and the mode of (poor, poor, below average, average,
average, average, average, good, good, excellent) is average.
Numerical Example
Table 14.1 shows an ordered array (in ascending order) of a 36-item random sample
of garden-level apartment rents. The data set illustrates the sample mean, median,
and mode. The same data is used later to illustrate measures of dispersion and shape.
Because the sample has an even number of observations, the median is the mid-
point between the 18th and 19th ordered observations, which is $825. The most fre-
quently occurring rent is $850, which occurs six times and is the mode of the data set.
Since the observations in the sample were randomly selected, the measures of central
tendency can be used to infer the corresponding population central tendency.
Often inference can be improved by use of a stratified random sample. For
example, if garden apartment units exist in one-bedroom and two-bedroom configu-
rations in a given market, and it is known that one-bedroom units represent 35% of
the garden apartment population, then a stratified random sample consisting of 35%
one-bedroom garden apartment units and 65% two-bedroom garden apartment units
would provide improved inferences on population parameters by ensuring that the
unit type variability within the sample is consistent with the underlying population.
Measures of Dispersion
Measures of dispersion indicate how much variation occurs in a given variable.
These measures are useful because they can be compared to the characteristics of a
known distribution—such as the normal distribution—to determine whether a par-
ticular set of parametric inferential statistics can be used. For example, if the data is
sufficiently close to being normally distributed, then statistical methods based on the
normal distribution can be employed to make inferences about the parameters of the
underlying population. Measures of dispersion also facilitate comparison of two data
sets to determine which is more variable.
Standard Deviation and Variance

The two fundamental measures of dispersion—standard deviation and variance—
take into account how all of the data is distributed. In addition, the standard devia-
tion lends itself to further statistical treatment, allowing inferences to be drawn and
statements to be made regarding the degree of uncertainty associated with an infer-
ence. For this reason, the standard deviation is a commonly calculated and reported
sample statistic. The population standard deviation is denoted by the Greek letter s
(“sigma”), and the sample standard deviation is denoted by the letter S.

Table 14.1 Garden-Level Apartment Rents
Monthly Rent Monthly Rent Monthly Rent Monthly Rent
$600 760 825 860
650 785 825 860
695 800 825 890
710 800 850 890
715 805 850 920
730 815 850 920
735 820 850 930
735 820 850 970
760 825 850 995
Sx = $29,370
n
S x $29,370
i=1 i
Simple Mean = x =
n = 36 = $815.83
Measure Calclulation
standard deviation
The square root of the variance. The sample standard deviation is the Population Standard
square root of the sample variance, and the population standard Deviation (s)
√
deviation is the square root of the population variance, i.e., the square S(xi - m)2
root of the sum of the squared deviations from the mean divided by either s=
N
the population size or by the sample size minus 1.
where
m = population mean
N = population size
Sample Standard
Deviation (S)
√ S(xi - x)2
S=
n - 1
where
x = sample mean
n = sample size
variance
In statistics, a measure of the degree of dispersion of a variable’s values; Population Variance
a measure of the extent to which observation values vary from the mean s2
value. Sample Variance
S2
Variance is simply the square of the standard deviation. Sample variance equals
S2, and population variance equals σ2. The sample standard deviation for the sample
of 36 apartment unit rents is calculated in Table 14.2.
When data is normally distributed, approximately 68% of the observations are
expected to lie within ± 1 standard deviation of the mean, 80% within ± 1.28 standard

Table 14.2 Sample Standard Deviation (S) Calculation
Rent (xi) Sample Mean (x) (xi − x) (xi − x)2
600 815.8333 -215.8333 46,584.01
650 815.8333 -165.8333 27,500.68
695 815.8333 -120.8333 14,600.69
710 815.8333 -105.8333 11,200.69
715 815.8333 -100.8333 10,167.35
730 815.8333 -85.8333 7,367.36
735 815.8333 -80.8333 6,534.02
735 815.8333 -80.8333 6,534.02
760 815.8333 -55.8333 3,117.36
760 815.8333 -55.8333 3,117.36
785 815.8333 -30.8333 950.69
800 815.8333 -15.8333 250.69
800 815.8333 -15.8333 250.69
805 815.8333 -10.8333 117.36
815 815.8333 -0.8333 0.69
820 815.8333 4.1667 17.36
820 815.8333 4.1667 17.36
825 815.8333 9.1667 84.03
825 815.8333 9.1667 84.03
825 815.8333 9.1667 84.03
825 815.8333 9.1667 84.03
850 815.8333 34.1667 1,167.36
850 815.8333 34.1667 1,167.36
850 815.8333 34.1667 1,167.36
850 815.8333 34.1667 1,167.36
850 815.8333 34.1667 1,167.36
850 815.8333 34.1667 1,167.36
860 815.8333 44.1667 1,950.70
860 815.8333 44.1667 1,950.70
890 815.8333 74.1667 5,500.70
890 815.8333 74.1667 5,500.70
920 815.8333 104.1667 10,850.70
920 815.8333 104.1667 10,850.70
930 815.8333 114.1667 13,034.04
970 815.8333 154.1667 23,767.37
995 815.8333 179.1667 32,100.71
Σ(xi − x)2 = 251,175.00
√
S = S(xi − x) =
√
251,175.00 = $84.71
2
n - 1 36 - 1
deviations of the mean, and 95% within ± 2 standard deviations of the mean. For this
data set, 25 observations (69%) lie within ± 1 standard deviation of the mean, 30 obser-
vations (83%) lie within ± 1.28 standard deviations of the mean, and 34 observations
(94%) lie within ± 2 standard deviations of the mean. Based on these measures, the
data appears to be approximately normally distributed.
Coefficient of Variation
The coefficient of variation (CV) is useful for relative
comparisons of dispersion among multiple sets of data
coefficient of variation
because dispersion is standardized to each sample’s
The ratio, expressed as a
percentage, of a variable’s mean. This is done by stating standard deviation as a
standard deviation to its percentage of the sample mean as follows:
arithmetic mean. S × 100
CV =
x

Parametric and Nonparametric Statistics
A parametric statistic is a statistic whose interpretation and validity is determined by understanding the
distribution of the underlying population data from which a representative sample has been drawn. Many
parametric statistics rely on an assumption that the population is normally distributed.
In contrast, a nonparametric statistic is a statistic whose interpretation and validity do not rely on know-
ing the distribution of the underlying population data from which a representative sample has been drawn.
Nonparametric statistics involves the use of inferential methods that are valid regardless of the underlying
population data distribution.
Inferences on medians (as opposed to inferences on means) derived from nonparametric statistics are
useful for analyzing small samples when the underlying population distribution is unknown and the sample
is so small that the central limit theorem cannot be relied upon to ensure approximate normality of the
sampling distribution of the mean.
Although nonparametric median tests are beyond the scope of this chapter, note that many software
packages provide a number of nonparametric tests that are appropriate for making inferences about central
tendency and distribution from a single sample and comparing the central tendencies of two or more small
samples. For example, the SPSS and Minitab software packages include several nonparametric single-sam-
ple analysis tools as well as independent-sample comparison tests and related-sample comparison tests.
Because real property data sets often consist of small-sized samples, it is useful to be able to apply a
nonparametric test. Many introductory statistics textbooks include chapters dealing with nonparametric
statistics, providing a level of understanding sufficient for most real estate applications.
The sample having the greatest coefficient of variation has the most widely dispersed
data.
For the apartment rent data set, the coefficient of variation is
$84.71
CV = × 100% = 10.38%
$815.83
Range
The range is a simple measure of the spread of the data. range
It is the difference between the values of the largest In statistics, the difference be-
observation and the smallest observation. When data is tween the highest and lowest
values in a set of numbers.
normally distributed, the range will be approximately
equal to 6 standard deviations (+3S to -3S), and 99.7%
of a normal distribution falls within this 6S range. The
range for the apartment rent data is $600 - $995, or
$395. This range equates to 4.66 standard deviations, i.e., less dispersion than would
be expected for a normally distributed data set.
Interquartile Range
A data set’s ordered array can be divided into four subsets of identical size by identi-
fying quartiles. Quartiles are useful for analyzing the shape of the data distribution,
which will be illustrated in the next section of this chapter.
Quartile 1 (Q1) ends at the midpoint between the lowest value and the median.
Quartile 2 (Q2) ends at the median, and Quartile 3 (Q3) ends at the midpoint between
the highest value and the median. Fifty percent of the ordered array of data falls
between Q1 and Q3 in this interquartile range.
The following decision rules also apply:

1. If the position point calculation is an integer, then the ordered observation oc-
cupying that position point is the quartile boundary.
2. If the position point is halfway between two integers, then the midpoint between
the next-largest and next-smallest ordered observation is the quartile boundary.
3. If the position point is neither an integer nor halfway between two integers,
then the position point is rounded to the nearest integer and the corresponding
ordered observation is the quartile boundary.
For a more precise (and advanced) analysis, linear interpolation is used to find
quartiles. Q1 equals one-fourth of the total distance between the first and second
quarters of data, Q2 equals two-fourths (or one-half) of the total distance between the
second and third quartiles, and Q3 equals three-fourths of the total distance between
the third and fourth quarters of data.
For the apartment rent data (36 observations), the position for Q1 is 9.25 (37 ÷ 4)
rounded down to the ninth ordered observation in accordance with the third decision
rule above. Position 9 in the ordered array corresponds to $760, which is Q1. Q2 is the
median, which is $825. The position for Q3 is 27.75 (111 ÷ 4) rounded up to the 28th
ordered observation in accordance with the third decision rule above. Position 28 in
the ordered array corresponds to $860.
The interquartile range is Q3 - Q1, or $860 - $760 = $100. When data is normally
distributed, the interquartile range should be approximately equal to 1.33 standard
deviations. For the apartment rent data, the interquartile range is 1.18 standard
deviations ($100 ÷ $84.71). For a more precise analysis, linear interpolation could be
used to find quartiles, as explained in the previous example.
Measures of Shape
Measures of shape are essential for determining how close to normal a data distribu-
tion is and the extent to which extreme values are distorting the difference between
the median and the mean. The normal distribution, which is the basis for many
statistical inferences, is symmetrical—i.e., its median and mean are equal. Figure
14.2 shows a normal distribution with a mean of $815.83 and a standard deviation
of $84.71. This plot, generated using Minitab statistical software, illustrates how the
apartment rent data set would have been distributed if it were perfectly normal. The
mean and median would both have been $815.83, and
the distribution would have been symmetrical.
normal curve A useful graphic illustration of shape is the box
A symmetrical, bell-shaped and whisker plot, which helps illustrate the extent of
curve that represents the skewness, or lack of skewness, in the data distribution.
distribution of a population
of certain types of measure- (Skewness will be discussed shortly.) A box and whis-
ments or the frequency ker plot is based on what is referred to as a five-number
distribution of all possible summary. The summary includes
means in large samples
that may have been drawn 1. The lowest value
from an unknown population 2. Q1
distribution. Also known as 3. The median
a normal distribution or nor-
mal probability distribution. 4. Q3
5. The highest value

The five-number summary for the sample apartment rent data is $600, $760, $825,
$860, and $995. The corresponding box and whisker plot, a graphic representation of
the five-number summary, along with the sample mean, is shown in Figure 14.3.
Skewness
The apartment rent data is not perfectly normal. Figure 14.3 shows that the sample data
is skewed (i.e., concentrated more densely) to the left, both in terms of the interquartile
Figure 14.2 The Normal Curve
Measure Location
interquartile range
A measure of dispersion. The interquartile range indicates the “distance” Quartile 1 (Q1)
between the value dividing the first and second quartile from the value n+1
dividing the third and fourth quartile. Q1 =
4
Note that a quartile is a descriptive statistic referring to one of three
values that divides arrayed sample or population variable values into four ordered observation
equal parts. For example, the first quartile separates the lower 25% from Quartile 2 (Q2)
the upper 75%. The second quartile (median) divides the data in half. Q2 = median
Quartile 3 (Q3)
3(n + 1)
Q3 =
4
ordered observation
Note that Excel calculates quartiles in
a different manner.

Figure 14.3 Box and Whisker Plot
$815.83
(mean)
$600.00 $760.00 $860.00 $995.00

(min.) (Q1) Q3 (max.)
$825.00
(median)
range ($825 - $760 > $860 - $825) and in terms of the tails ($760 - $600 > $995 − $860).
Another indication of skewness is the relationship between the median and the
mean. When data is left-skewed, the mean will be less than the median. When the
data is right-skewed, the mean will be greater than the median. The mean is included
in Figure 14.3 to further illustrate the degree of left skewness.
Skewness can also be captured through a graphic depiction of a frequency or
percentage distribution. These graphic displays are called histograms. Figure 14.4 il-
lustrates a combination frequency and percentage distribution for the apartment rent
data and the related percentage histogram.
The percentage histogram is derived from conversion of the numerical price data
(monthly rent) to categorical data (rent category) reflecting percentages of the sample
items within each class. If the rent data was symmetrical, the distributions to the
right and left of center would be mirror images. Instead, the left side extends farther
from the center (i.e., left skewness).
Spreadsheet programs and statistical software packages such as Excel, Minitab,
and SPSS provide more quantitative assessments of skewness within their descrip-
tive statistics measures. In the formula for calculating the measure of skewness, if a
data distribution is symmetrical, the value in the parentheses following the summa-
tion sign is zero and the measure of skewness is zero. If the data distribution is left-
skewed, the value in the parentheses following the summation sign is negative and
Measure Calculation
skewness
The degree of deviation from symmetry in a statistical distribution. Skewness
( )
n xi - x 3
Skewness = S

(n - 1)(n - 2) S
where
x = sample mean
n = sample size
S = sample standard deviation

Figure 14.4 Frequency and Percentage Distributions with Percentage Histogram
Rent Category Frequency (Count) Percentage of Total
Less than $650 1 2.8%
$650 to $699 2 5.6%
$700 to $749 5 13.9%
$750 to $799 3 8.3%
$800 to $849 10 27.8%
$850 to $899 10 27.8%
$900 to $949 3 8.3%
$950 or more 2 5.6%
Percentage Histogram
30.0%
25.0%
20.0%
Percent
15.0%
10.0%
5.0%
0.0%
Less than $650 to $700 to $750 to $800 to $850 to $900 to Greater
$650 $699 $749 $799 $849 $899 $950 than $950
Rent Category
the measure of skewness is negative. If it is right-skewed, the value in the parenthe-

ses following the summation sign is positive and the measure of skewness is positive.
Skewness for the apartment rent data is -0.312, indicating left skewness as depicted in
the box and whisker plot and the percentage histogram.
Kurtosis
The statistical term kurtosis refers to the degree of “peakedness” in a data distribu-
tion—that is, the height of the probability distribution and thickness of its tails.
Curves with kurtosis of 3 are called mesokurtic. (Kurtosis values are most often
calculated using Excel, Minitab, SPSS, or other statistical software. They are seldom
calculated by hand.) The normal distribution has kurtosis equal to 3. More peaked
curves (leptokurtic) have values larger than 3 and less peaked curves (platykurtic) have
values less than 3. (See illustrations of various degrees of kurtosis in Figure 14.5.) The
apartment rent data set is less peaked (kurtosis = 0.42) than a normal distribution.
Normality
The apartment rent data appears to be approximately normal based on a menu of
measures, including the proportions of observations lying within the mean plus or
minus 1, 1.28, and 2 standard deviations and the number of standard deviations
encompassed by the range and the interquartile range. However, as these statistics
show, the fit to normality is seldom perfect. The rent data is slightly left-skewed and,

Figure 14.5 Kurtosis
Leptokurtic Mesokurtic (normal distribution) Platykurtic
as mentioned previously, the range is 4.66 standard deviations, slightly less than the
normal expectation of 6 standard deviations.
Quantitative tests for normality and normal probability plots are useful for as-
sessing the degree of departure from normality. Data points that are perfectly normal
will line up along a straight-line normal probability plot, whereas data points that
depart from normal will depart from a straight line that is representative of a per-
fectly normal distribution. The normal probability plot shown in Figure 14.6 confirms
the prior assessment that the apartment rent data is not perfectly normal, but the plot
does provide a reasonably close fit. The normal probability plot was generated in
Minitab, and the output includes other useful information such as the mean, the stan-
dard deviation, and the results of a Komolgorov-Smirnov test (KS test) for normality.
The p-value from the KS test indicates that the hypothesis that the data was drawn
from a normally distributed population cannot be rejected.
The p-value represents the probability of something occurring if the assump-
tion underlying the analysis is true. For example, in this test the analyst asks, “If the
population is normal, what is the probability of drawing a sample that departs from
normal to the extent this one does?” The p-value of 15% indicates that the analyst
could expect a sample derived from a normal population to depart from normal to
the extent this one does 15% of the time. Generally, a p-value of 5% or less would
provide convincing evidence of a sample drawn from a non-normal population.2
2. Minitab provides two additional normality tests (Anderson-Darling and Ryan-Joiner tests), which also fail to reject the normality hypothesis.
Normality tests are also available in SPSS.

Figure 14.6 Normal Probability Plot of Rent
To reiterate the importance of the measures of shape, these metrics are helpful in
assessing the extent to which a data distribution conforms to the normal distribution
and determining if extreme values are distorting the difference between the median
and the mean. If the data distribution is too far from normal, then inferential tests
based on assumptions of normality (e.g., t-tests and F-tests) may not be applicable to
small samples. In addition, if extreme values in the data are distorting the arithmetic
mean, then the median is likely to be a better indicator of central tendency.
Central Limit Theorem and Inference

Although the most popular and user-friendly inference tests are based on the as-
sumption that a sample has been derived from a nor-
mally distributed population (i.e., the so-called “bell
curve” with skewness = 0 and kurtosis = 3), normality- central limit theorem
based inferences concerning non-normally distributed A statistical principle that
populations can be made if the sample size is large identifies the tendency of
enough. The adequacy of the sample size depends on the sampling distribution
the underlying population distribution. of the mean to become
Generally, the sampling distribution of a mean approximately normal as the
size of the sample increases,
drawn from the population—regardless of the shape without regard to the shape
of the underlying population distribution—will be of the distribution of the
approximately normal with a sample size of at least underlying population.
30, according to the central limit theorem. The sampling

distribution of the mean refers to the distribution of the sample mean. Creation of a
distribution of a sample mean entails taking numerous random samples from a given
population, calculating the mean of each random sample, and then examining the
distribution of those means.
When sampling from a nonsymmetrical population, a sample size of at least 30 is
required to ensure approximate normality of the sampling distribution of the mean.
If the underlying population is fairly symmetrical (like the apartment rent data), the
sampling distribution of the mean will be approximately normal with a sample size
of at least 15. If the underlying population is normally distributed, then the sampling
distribution of the mean is also normal, regardless of sample size.3 The central limit
theorem’s importance is that it allows inferences to be drawn without knowing the
actual distribution of the underlying population.
The apartment rent data sample consists of 36 observations. It can be used to
make inferences about the mean of the underlying population rent because the size
of the sample meets the criteria of the central limit theorem. The rent data has been
drawn from a population with an unknown mean and standard deviation. Population
standard deviation is rarely known when making inferences about the true population
mean because µ must be known in order to calculate σ. Logically, if µ is known, then
there is no need to infer it. However, in rare cases a population has been studied so
many times that many estimates on S have been previously published, and they can
be relied upon as estimators of σ rather than using S from a sample.
The sample data can be used to infer the underlying population mean because a
probability sample (e.g., a simple random sample) was drawn. The sample mean (x)
is $815.83 and the sample standard deviation (S) is $84.71.
A confidence interval reflects the degree of uncertainty associated with an inference.
It is a range accompanied with a statement of probability or confidence that the range
contains the parameter being estimated. Any inference should be accompanied by this type of
statement. The confidence interval for the mean, when the population standard devia-
tion is unknown, can be derived from the Student’s t distribution when the sample size
is sufficient to invoke the central limit theorem or when the population is known to be
normally distributed. When n = 36, values of t35 are 1.6896 for a 90% confidence interval,
2.0301 for a 95% confidence interval, and 2.7238 for a 99% confidence interval.
These t values can either be looked up in a statistical table or calculated using
statistical software. Excel, Minitab, and SPSS will calculate a confidence interval from
a data set, given input on the level of confidence sought. The associated confidence
intervals on the true population mean price for the apartment rent data are
90% confidence $791.98 ≤ µ ≤ $839.68
95% confidence $787.17 ≤ µ ≤ $844.49
99% confidence $777.37 ≤ µ ≤ $854.29
With 90% confidence, the degree of uncertainty concerning the value of the true
mean is 10%. Uncertainty reduces to 5% and 1% as confidence rises, but the associ-
ated “cost of less uncertainty” is a wider confidence interval. The level of uncertainty
is referred to as “alpha” (α) in statistics, and the confidence level is 1 - α. Alpha is the
probability of making a “Type I Error”—inferring µ to be within a confidence interval
3. See David M. Levine, Timothy C. Krehbiel, and Mark L. Berenson, Business Statistics: A First Course, 3rd ed. (Upper Saddle River, NJ: Prentice
Hall, 2003), 237-239.

Measure Calculation
confidence interval
In statistics, the specification of a zone within a population, based on a Confidence Interval
sample mean and its standard error, within which the true mean most Confidence interval on µ (σ
probably lies. unknown)
S
x ± tn - 1
√n
where
x = sample mean
n = sample size
S = sample standard deviation
t = Student’s t distribution
when it is not. “Type II Errors” are referred to as “beta” (β)—inferring µ to be outside

of the confidence interval when it is actually within the interval.
Sample Size
Suppose a client requires a narrower confidence interval without increasing α. Notice
that the width of the confidence interval is reduced when n is increased due to divi-
sion by the square root of n. In addition, the value of t becomes smaller at a given
confidence level as sample size increases. As a result, narrower confidence intervals
can be achieved by collecting a larger sample.
A requisite sample size can be estimated to accommodate a predetermined
amount of sampling error (e). The equation for sample size is
Z2σ2
n=

e2
The standard normal distribution Z is used in this calculation because the value of t can-
not be determined until a sample size has been selected. Consequently, this calculation
yields an approximate sample size. Furthermore, it is not unusual for some proportion of
collected data to be unusable due to missing variables or “nonresponse.” It is good prac-
tice to attempt to collect a sample that is comfortably larger than indicated by the sample
size calculation. As calculated here, sample size is an estimate of the number of usable
observations needed to control the size of sampling error at a given level of confidence.
The sampling error from the 36-unit rent sample for the 95% confidence interval
on true mean monthly apartment rent is $28.66 [($844.49 - $787.17) ÷ 2]. Suppose,
however, that the needs of the client dictate that a sampling error no larger than $15
is acceptable at a 95% confidence level. In order to calculate a revised sample size, Z
is derived from the standard normal distribution and is equal to 1.96 at a 95% confi-
dence level. The population standard deviation (σ) is unknown but can be estimated
as $84.71 based on the previous calculation of S. (The population standard deviation
is usually unknown and must be estimated based on prior research, a pilot sample,
or other bases used to support an assumption.) On this basis, the sample size would
have to be increased to at least 123 observations, computed as follows:
1.962 × 84.712
n= = 122.5
152

Sample size is always rounded up. Furthermore, because t122 is approximately
1.9799, the sample size could be increased to 126 based on the difference between the
standard normal Z and t122, as follows:
1.97992
123 × = 125.5
1.962
As this example demonstrates, increased inference precision can add to the
expense of data collection. Here an approximately 48% reduction in sampling error
from $28.66 to $15 results in a need to increase sample size by almost 250%. Obvi-
ously, mean apartment rent could be known with certainty by analyzing a census of
all apartments in a market. In many cases, however, it simply is not possible or is too
costly to collect data on each item in a population.
Regression Analysis
Regression analysis is a statistical technique in which a mathematical equation can
be derived to quantify the relationship between a dependent (outcome) variable and
one or more independent (input) variables. In appraisal, the dependent variable is
usually price or rent. The independent variables are usually broadly derived from
the four forces that affect value (social, economic, governmental, and environmental)
and the physical characteristics of the land and improvements. Often, data collection
protocols control for the four forces that affect value by focusing on property sales or
rents that are subject to common social, economic, governmental, and environmental
influences. The relevant physical characteristics of comparable property data (site
and improvement information) should be included as independent variables, unless
all of the comparable properties and the subject property are identical in some physi-
cal aspect (e.g., all are stucco, all have two-car attached garages, or all are located on
interior lots of identical size). In some instances, it is also necessary to include a date
of sale variable (or variable set) to account for economic change over time. In ad-
dition, it is not uncommon to include an environmental variable or variables when
investigating the effects of an external environmental factor such as traffic noise or
factory odor.
Regression models have been used for mass ap-
praisal by property tax assessors for many years, espe-
regression analysis cially in highly developed residential markets, because
A statistical method that regression modeling is more resource-efficient than
examines the relation- performing a traditional appraisal for each property in
ship between one or more a large assessment district with an active real property
independent variables and a market. Regression modeling is often the logical choice
dependent variable. Regres-
sion models can be used to for tax assessment, when the alternative is to appraise
examine the structure of a each property individually and resource constraints
relationship or to forecast prohibit doing so as often as would be necessary to
dependent variable values. ensure equitable taxation.
Simple linear regression has Regression models (along with expert systems and
one independent variable,
whereas multiple linear re- neural networks, which are discussed briefly below)
gression includes more than also form the basis for many automated valuation
one independent variable. models (AVMs), of which mass appraisal models are a
subset. AVMs initially became important in the 1990s

as residential lenders began to concentrate on shortening loan approval turnaround
time to compete more intensely on transaction fees.
Statistical Applications in Appraisal Practice

The widespread use of personal computers, spreadsheet programs, and statistical soft-
ware has allowed appraisers to incorporate statistics into their analyses and appraisal
reports easily and accurately. In the early years of personal computing for business,
statistical analysis was generally limited to providing descriptive statistics and accom-
panying charts, tables, and graphs. As graphical user interfaces became more preva-
lent in operating systems, statistical programs such as SPSS, Minitab, and SAS became
more user-friendly, largely because the user no longer had to write programming code.
As computer users have become more sophisticated, spreadsheet programs have
added statistical tools to meet the needs of customers. Currently, Microsoft Excel
includes a statistical tool pack that will generate statistical output such as correlation
matrices, F-tests of variances, t-tests of means, and linear regression models. How-
ever, Excel provides very little in the way of diagnostics to accompany its inferential
tools. Excel’s statistical strength continues to be in its charting capabilities.
Automated Valuation Models

The automated valuation models used by appraisers today originated with the tax
assessment mass appraisal techniques and tools that existed long before the advent of
AVMs. Property tax assessors developed mass appraisal models to improve produc-
tivity and fairness in non-rural locations where manpower was insufficient to carry
out the function of estimating assessed value. In addition, in the early years of mass
appraisal, tax assessors were in a unique position to take advantage of large amounts
of data that had been converted into a computer-readable format. Assessors con-
tinue to use AVMs as a means of automating assessment and making use of the large
amounts of digitally coded data they possess. Internet access to more reliable data
from taxing authorities and third-party data sources has enabled most appraisers to
access the large data resources required for statistical analyses.
The initial research on AVMs pitted neural networks and expert systems against
regression-based models. In essence, neural networks
“learn” the relationships among variables to develop
and continually update an internal and unknowable
algorithm for estimating price. Neural networks can automated valuation model
(AVM)
be considered “atheoretical” in that their algorithms
Computer software that
can only be tested by comparing estimation results to queries property and market
a known standard. Because of their “black box” deci- data, analyzes comparable
sion model, neural networks have not developed a property and market informa-
large practical following. Professional standards do not tion to assign a value or
require that appraisers know or be able to explain an range of values to a particular
property, or generates metrics
AVM’s algorithm, but appraisers should be able to ex- applicable to assessing the
plain the overall estimation process and verify that the credibility of valuation-related
AVM consistently produces results that accurately re- statements or conclusions.
flect market behavior.4 Unlike neural networks, expert
4. See Advisory Opinion 18 of the Uniform Standards of Professional Appraisal Practice: Use of an Automated Valuation Model (AVM).

systems develop decision
Professional Standards and the Use of an AVM models that attempt to
According to Advisory Opinion 18 of the Uniform Standards of Pro- mimic expert (i.e., ap-
fessional Appraisal Practice: Use of an Automated Valuation Model
praiser) behavior. They
(AVM), an appraiser should be able to answer affirmatively to the
following questions before deciding to use an AVM in an appraisal or essentially automate the
appraisal review assignment: human problem-solving
1. Does the appraiser have a basic understanding of how the AVM process. For example,
works? some AVMs employ an
2. Can the appraiser use the AVM properly? expert systems layer for
3. Are the AVM and the data it uses appropriate given the intended such tasks as selecting
use of assignment results? comparable sales or com-
4. Is the AVM output credible? parable rents.
5. Is the AVM output sufficiently reliable for use in the assignment? Regression-based
AVMs apply multiple re-
gression models at some
level within the valua-
tion product to produce a value-estimation equation, a value estimate, adjustment
coefficients for automatically selected comparable sales or rents, or some combina-
tion of these outputs. Many AVMs now include other features that enable appraisers,
appraisal reviewers, and underwriters to produce and review descriptive statistics
by user-defined property characteristics, market area, subdivision, zip code, city, or
county. These features provide scales of reasonableness against which the conten-
tions, assumptions, and conclusions of appraisers can be measured. In addition to
this quality control function, AVMs also enhance a lender’s ability to prequalify bor-
rowers, conduct audits, mitigate loss, assess portfolios of loans, provide home equity
loans, and engage in numerous other functions.
Although AVMs were initially perceived as a means of replacing human apprais-
ers with machines, they have developed more recently into underwriting devices and
tools designed to assist appraisers and appraisal reviewers. Professional standards
note that “the output of an AVM is not, by itself, an appraisal.”5 According to the
Uniform Standards of Professional Appraisal Practice, the output of an AVM may
be used as a basis for opinions and conclusions in an appraisal or appraisal review
assignment if the appraiser believes that the output is credible for use in a specific as-
signment. Today, practicing real estate appraisers are working to gain an understand-
ing of AVM technology and shifting markets for appraisal services to determine how
best to take advantage of new business opportunities resulting from AVMs.
Currently a variety of AVM products are offered nationally, and new products
emerge constantly. As the lending industry works through issues and problems
related to data reporting, data transfer, data accuracy, and modeling, AVM standards
are continually being refined by professional organizations such as the Mortgage
Bankers Association, the Mortgage Industry Standards Maintenance Organization,
and others.
Custom valuation models represent another opportunity for appraisers to incor-
porate statistical applications into their practices. Given access to adequate amounts
of data, which are generally more readily available in single-unit residential and
rental apartment markets than in most commercial markets, appraisers with ade-
5. See Advisory Opinion 18 of USPAP.

quate statistical modeling skills and appropriate software can apply statistical models
to customized, unique valuation questions. Applications vary widely and include
• Property tax assessment and equity studies
• Price or rent trend analysis
• Augmentation of traditional valuation approaches
• Impact studies addressing the effects of nuisances or environmental hazards
• Preparation of value estimates for litigation
Some custom applications are straightforward and easily modeled, and others
are complex and difficult to model. Production of a credible work product is of para-
mount importance. Appraisers should not attempt to build a statistical model that is
beyond the limits of their education and experience. As with any appraisal specialty,
the ability to address complex statistical problems grows with experience. Experience
is best gained by collaboration with a more qualified statistical analyst and participa-
tion in continuing education to build skill sets.

Market Analysis 15
The term market analysis is used broadly in economics to describe the identification
and study of the market for a particular economic good or service. However, the term
has a more specific meaning within the discipline of real property appraisal. For ap-
praisers of real property, market analysis is a study of the supply of and demand for a
specific type of property in a specific market area.
Depending on the nature of the market and the intended use and intended user
of the appraisal report, an analysis of real estate markets can range from simple and
straightforward to complex, particularly if a large amount of primary research is re-
quired. Most market analysis assignments can be performed using a six-step process,
which is illustrated in Figure 15.1. Note that the six-step process includes marketabil-
ity analysis as the final step.
As outlined in Chapter 10, real estate markets can be analyzed from the perspec-
tives of two different categories of market participants:
1. Buyers and sellers of
real estate assets as Figure 15.1 The Six-Step Process
part of the capital in-
vestment market, i.e., Step 1. Property productivity analysis: analyze competitive characteristics
of the subject property
the “transactional”
Step 2. Market delineation: identify demand sources and competitive area
asset market
Step 3. Demand analysis: estimate current demand and predict future
2. Users of space, i.e., demand
the “fundamental” Step 4. Supply analysis: survey existing supply and predict future changes
market of users of the Step 5. Residual demand analysis: analyze the interaction of supply and
physical space provid- demand
ed by the real estate in Step 6. Subject capture analysis: determine conclusions of marketability
a market area1 analysis, i.e., predict performance of the subject property
1. For more in-depth discussion of the distinction between asset markets and fundamental markets, see Chapter 10 and Stephen F. Fanning, Market
Analysis for Real Estate: Concepts and Applications in Valuation and Highest and Best Use, 2nd ed. (Chicago: Appraisal Institute, 2014), 5, 177-189.
Analyses of both real estate market segments are important in the valuation process,
but the characteristics of those two separate market segments and their relevance
in market analysis, highest and best use analysis, and the application of the three
approaches to value need to be recognized. Real estate prices are a function of both
of these markets. The fundamental market determines how much income an income-
producing property will generate because it determines the occupancy rate and rental
rates. When there is an oversupply, vacancy increases and rents decline. When there
is an undersupply, vacancy rates decrease and rents increase. The capital market is
made up of investment capital (i.e., debt and equity) representing demand and prop-
erties available for purchase representing supply. When there is an increase in capital
(i.e., investors) and fewer properties are available for purchase, capitalization rates
and discount rates decline. When there is a decrease in the number of investors look-
ing for investments, capitalization rates and discount rates increase.
The fundamental market determines how much income a property makes, and
the capital market determines the cap rate, multiplier, or discount rate that should be
applied to that income. Both forms of market analysis discussed in this chapter—fun-
damental analysis and inferred analysis—study the space user market. The analysis
of capital markets is a separate step that is not generally addressed in the market
analysis section of an appraisal report. Instead, appraisers tend to leave analysis of
the capital market to the valuation sections of the report.
Distinguishing Marketability Analysis from Market Analysis

The label marketability analysis has traditionally been used when the scope of the analysis extends beyond
general market analysis to investigate how a specific property is expected to perform in its market. However,
in strictest usage, marketability analysis most precisely describes the final step in the formal six-step pro-
cess. Marketability analysis is an essential step in the process of developing an opinion of market value and
should not be confused with the analysis of general demographic or economic information for an area.
In an appraisal of a specific property, the main purpose of marketability analysis is to show how the
interaction of supply and demand affects the property’s future benefits to the owner in terms of the use
of the property over time. To complete a marketability analysis (in the sixth step of the six-step process),
an appraiser must first complete a market analysis (i.e., the preceding steps of the six-step process). For
example, consider the appraisal of a neighborhood shopping center. A market analysis would measure the
demand and competition for all neighborhood shopping centers in a specified market, which may cover a
two-mile area. A marketability analysis would then compare how a particular property (e.g., the property be-
ing appraised) will perform in that market given the relevant demand and competition. The conclusions of the
marketability analysis then become the basis for determining the value implications for the property.
Marketability analysis may perform several functions: (1) to determine the market outlook and trends for
marketing a property, (2) to address the desired type, design, and locational characteristics of a develop-
ment, (3) to provide estimates of the share of the market that the property is likely to capture during its
economic life and its probable absorption rate, or (4) to suggest alternative uses in a market in which the
existing use of a specific property is oversupplied or outdated.
Marketability analysis also provides a basis for determining the highest and best use of a specific property
in a defined market. In short, the market determines the appropriate use, and the use drives the value. An
existing or proposed use may be put to the test of maximum productivity in highest and best use analysis
only after it has been demonstrated that an appropriate level of market support exists for that use. In-depth
marketability analyses specify the character of that support. For example, if current market conditions do
not indicate that adequate demand for a proposed development exists, marketability analysis may identify
the point in time when there will be adequate demand for that land use. Thus, marketability analysis helps
appraisers forecast the timing of a proposed improvement and the amount of demand anticipated in a
particular period of time.

The market value of a particular property use is largely determined by the de-
mand for that use in the market and the competitive position of that property in its
market. Analysis of the characteristics and attributes of a property (generally called
property productivity analysis) enhances an appraiser’s ability to identify competitive
properties (i.e., supply) and to understand the comparative advantages and disad-
vantages that the subject property offers potential buyers or renters (i.e., demand).
An understanding of economic conditions, their effect on real estate markets, and the
momentum of these markets helps appraisers appreciate the externalities affecting a
property. In its broadest sense, therefore, market analysis provides vital information
needed to determine highest and best use and then measure value using the three
approaches to value, as shown in Table 15.1.
Table 15.1 Market Analysis and Marketability Analysis in the Approaches to Value
Approach to Value Uses of Market Analysis and Marketability Analysis
Cost Market analysis can provide appraisers with information about trends in land prices and con-
struction costs, current building costs, and market conditions. The conclusions of marketability
analysis help appraisers estimate the profit an entrepreneur can expect and any economic
advantage or obsolescence.
Sales comparison Market analysis provides appraisers with a thorough understanding of current market condi-
tions, the future market outlook, and the subject property’s ability to compete in this market.
The conclusions of marketability analysis provide support for many of the adjustments in
the sales comparison approach such as adjustments for location and market conditions.
Marketability analysis is also helpful in the analysis of the risk factor in capitalization rates
generated from the sales that have occurred.
Income capitalization Market analysis provides appraisers with important information used to forecast income and
to select appropriate capitalization rates. Marketability analysis allows appraisers to predict a
property’s sell-out rate and to estimate how the sell-out rate and lot or unit prices will change
over time. For income properties, marketability analysis can provide an estimate of lease-up
and includes a conclusion of current and future occupancy for the subject property. Market
analysis allows an appraiser to predict the change in rent or revenue over time. Marketability
analysis is also helpful in analyzing the risk characteristics of a property, which is necessary
to select the appropriate direct capitalization rates and discount rates.
In addition to its use in the application of the approaches to value, market

analysis is relevant to the final reconciliation of the value indications of the various
approaches applied in an appraisal. Market analysis helps appraisers determine the
relevance and reliability of each of the approaches to value and establishes confi-
dence in the final value opinion.
Foundations of Market Analysis for Real Estate

The discipline of market analysis for real estate has been built on the basic concepts
of valuation and the long tradition of economic analysis of market supply and
demand. The integral processes that all serve as the underpinnings of the formal six-
step process are
• Delineating a market
• Assessing demand for a product
• Surveying the competitive supply
Market Analysis 275

• Studying the interplay of supply and demand around a theoretical point of
equilibrium
• Tracking market trends
Market Definition and Delineation

At the outset of the six-step process, two things must be clearly identified:
1. The real estate product or service provided by the subject property
2. The real estate market in which the subject property competes
These two tasks can be complementary. That is, the identification and analysis of the
real estate product provide a portion of the information needed in the next step—
identifying the market area in which the property competes.
In the first step of the market analysis process—property productivity analysis—
appraisers identify the relevant characteristics of the property to be appraised and then
analyze the physical, legal, and locational characteristics that affect that property’s
ability to serve the uses for which it is designed. (This analysis includes a projection of
how long the property design will meet the needs of the space users in the market.)
Analyzing the characteristics and attributes of that real estate product also helps
appraisers identify the demand sources, which is called market delineation (Step 2).
The purpose of market delineation is to determine: (1) where demand comes from
and (2) which properties compete for this demand and serve the applicable market.
In the market delineation step of the six-step process, the geographic boundar-
ies of the real estate market area for the subject property are determined through an
appraiser’s examination of the location and characteristics of competitive properties.
Appraisers can further break down a specific real estate market into market segments
and can separate the properties in those market segments by characteristics such as
occupancy type, competitive class of property, location, or economic segment.
The concept of market delineation in the market analysis process should not be
confused with the establishment of a market area that comparable sales can be select-
ed from in the application of the sales comparison approach, as discussed in Chapter
22. In fundamental market analysis, the market consists of properties that would
compete for the same set of tenants or space users. In the sales comparison approach,
the best comparable sales are those that would attract the same set of potential buy-
ers. The best comparable sales might not be found in the same geographic area as the
market area relevant to potential users of the subject property as discussed here.
Demand
In the broadest sense of the term’s usage in economics, demand serves as a measure of
the needs, material desires, and purchasing power of consumers. In market analysis
for real estate, demand analysis—the third step in the market analysis process—fo-
cuses on identifying the potential users of a subject property such as the owner-occu-
pants, renters, clientele, or customers that a property will attract. For each particular
type of property, demand analysis focuses on the end product or service that the real
estate provides. For example, demand analysis for retail space would attempt to de-
termine the demand for retail services generated by potential customers in the market
area. A demand analysis for office space would attempt to identify businesses in the
area that occupy office space and their space or staffing needs. (Figure 15.2 illustrates
the important factors studied in demand analysis for various property types.)

Figure 15.2 Demand-Side Factors
Residential Market
• Population of the market area—size and number of households, rate of increase or decrease in household formation
• Income (mean or median per household and per capita)
• Employment types and unemployment rate
• Percentage of owners and renters
• Financial considerations such as savings levels and lending requirements (e.g., interest rates on mortgages, points
charged, loan-to-value ratios)
• Factors affecting the physical appeal of the neighborhood, e.g., geography and geology (climate, topography, drain-
age, bedrock, and natural or man-made barriers)
• Local tax structure and administration, assessed values, taxes, and special assessments
• Availability of support facilities and community services (cultural institutions, educational facilities, health and
medical facilities, fire and police protection, access to technology)
• Externalities (noise, odors, etc.)
Retail Market
• Population of trade areas—size and number of households, rate of increase or decrease in household formation,
composition and age distribution of households
• Per capita and household income (mean and median)
• Percentage of household income spent on all retail purchases and percentage of disposable income (effective
purchasing power) spent on various specific retail categories
• Rate of sales retention in the trade area (i.e., the net leakage out of the subject market area to sources such as
highly superior retail centers outside the subject market area and e-commerce, etc.)
• Existing sales volume per square foot
• Retail vacancy rate and trends in the market
• Percentage of retail purchases captured from outside the trade area (e.g., population outside the trade area, day-
time population in the trade area such as office workers)
• Accessibility (transportation facilities and highway systems) and cost of transportation
• Factors that affect the appeal of the retail center (image, quality of goods, and tenant reputation)
Office Market
• Area employers who use office space; current and estimated future staffing needs
• Average square foot area of office space required by an office worker—requirements vary according to the category of
work, the rank of the office worker, and the location of the office (e.g., in the suburbs or the central business district)
• Vacancy rate for the specific class of office building
• Move-up demand for space in Class A and Class B buildings or fall-out demand for space in Class B and Class C
buildings
• Land use patterns and directions of city growth and development
• Factors that affect the appeal of office buildings (quality of construction, management, high-performance features,
and mix of tenants) and the availability of support facilities (shops, restaurants, recreational centers) in the market
Industrial Market
• Presence of raw materials
• Exchange capability (currency values and trade barriers)
• Area employers who use industrial space; current and estimated availability of skilled and unskilled labor
• Land use patterns and directions of city growth and development
• Employment in manufacturing, wholesale, retail, transportation, communications, or public utilities
• National and regional economic growth that affects local demand
• Retail sales (applicable in market analysis for retail storage and wholesale distribution properties)
Market Analysis 277

Forecasts of change in demand are typically tied to three primary drivers of demand:
1. Employment
2. Population
3. Income
Demand for office space is typically based on employment in office-using industries.
Demand for industrial space is often based on industrial employment or on popula-
tion or economic factors that contribute to industrial demand. Residential demand is
typically based on the current number of households and forecasted change in that
number. Retail demand is primarily a function of disposable household income.
Employment is a primary predictor of real estate demand for all property types
because changes in employment start a chain reaction, as shown in Figure 15.3.
Employment growth leads to growth in demand for both office space and industrial
space, which in turn leads to an increase in demand for housing (especially in close
proximity to the new office and industrial jobs). And the growth in housing leads to
growth in demand for retail space close to the housing.
Demand analyses for residential and retail markets specifically investigate the
households in the subject property’s market area. (A household is defined as a number of
related or unrelated people who live in one housing unit. Thus, a single individual may
constitute a household, and familial status is not a consideration.) In addition to provid-
ing an estimate of the number of households in the market area, these analyses focus on
the disposable income—or effective purchasing power—of the households and the ages,
gender, and consumption preferences and behavioral patterns of household members.
Competitive Supply
In the context of market analysis for real estate, supply refers to the production and
availability of a real estate product. To analyze current supply—the fourth step in the
market analysis process—appraisers can compile an inventory of properties that com-
pete with the property being appraised, including known future competition and even
unknown but likely future competition that might become available during the market
cycle being studied. This can be estimated by analyzing competitive projects under
construction as well as
projects in the planning
Figure 15.3 Real Estate Demand Hierarchy and approval stage. Ap-
Employment Growth praisers also consider the
availability of develop-
ment sites that could
become competitive.
Growth in Office Space Growth in Industrial Space Data on supply in a
market may be gathered
in various ways:
• Field inspection
Growth in Housing • Review of building
permits (issued and
acted upon), plat
maps, and surveys of
Growth in Retail Space
competitive sites

• Interviews with developers and city planners
Figure 15.4 lists some factors appraisers study in analyzing the supply of competing
properties.
Care should be exercised in the development and analysis of data on proposed
or announced projects because ultimately the construction of some projects will not
be completed. One technique used to estimate the likely addition of supply through
new construction involves assigning probabilities of completion to proposed projects.
Appraisers should also determine the amount of space likely to be lost to demolition
and the amount of space added or removed through conversion.
Figure 15.4 Supply-Side Factors

• Quantity and quality of available competition
• Volume of new construction—competitive and complementary projects in planning and under construction
• Availability and price of vacant land
• Availability of construction loans and financing
• Costs of construction and development
• Currently offered properties (existing and newly built)
• Owner occupancy versus tenant occupancy
• Causes and number of vacancies
• Conversions to alternative uses
• Special economic conditions and circumstances
• Effect of building codes, zoning ordinances, and other regulations on construction volume and cost (e.g., energy-
efficiency standards that can increase building costs)
Market Equilibrium
Over the short term, the supply of real estate is relatively fixed, and prices are re-
sponsive to demand. If demand is unusually high, prices and rents will start to rise
before new construction can begin. The completion of new supply may lag consider-
ably behind the shift in demand. Thus, disequilibrium generally characterizes real
estate markets over the short term.
Theoretically, the supply of and demand for real estate move toward equilibrium
over the long term. However, this point of equilibrium is seldom achieved or main-
tained. In some real estate markets, such as those characterized by a specialized econo-
my, supply responds slowly to changes in demand. Real estate development is a time-,
capital-, and labor-intensive process including land use approval, design, financing,
and construction. Because projects can take months or years to complete, there is a lag
between when market participants recognize a need for new space and the completion
of new projects to meet that demand. If demand continues increasing during that lag,
the undersupply can become worse. Often, when new supply finally does come online,
the amount of new construction exceeds the excess demand, and the market moves into
an oversupply. A decline in demand is often caused by a change in the economy while
new real estate product is being constructed, further exacerbating the oversupply.
Trends in Market Conditions

Appraisers investigate the interaction of current supply and demand to determine cur-
rent market conditions, and then future supply and demand are compared to predict
Market Analysis 279

the change in market conditions. Occupancy rates are an indication of the balance of
supply and demand. Occupancy rates below the equilibrium level signify an oversup-
plied market, which can result in declining rents. Occupancy rates above the equilib-
rium level imply an undersupplied market, which can result in increasing rents.
Appraisers and market participants describe the activity of real estate markets in
a variety of ways. An active market is primarily characterized by numerous transac-
tions. Market observers might see growing demand, a corresponding lag in supply,
and an increase in prices. A depressed market is a market in which a drop in demand is
accompanied by a relative oversupply and a decline in prices.
Descriptive terms applied to markets are subject to interpretation. For example,
markets are sometimes characterized as strong or weak. Strong markets may reflect
either high demand and increasing price levels or a large volume of transactions.
Weak, or soft, markets may be identified by low demand, declining price levels, or a
reduced volume of transactions. Other loosely defined terms include broad and nar-
row markets, loose and tight markets, and balanced and unbalanced markets.
All markets cannot be described with simple characterizations. Sometimes sup-
ply and demand do not act as expected. For example, supply may fail to respond to
increasing demand because the rate of demolition or change of use exceeds the rate
of new construction. In this case, prices will continue to rise.
As shown in Chapter 10, the activity of the real estate market is cyclical. Like
the business cycle, the real estate cycle is characterized by successive periods of
expansion, contraction, recession, and recovery. The real estate cycle is, however, not
necessarily synchronized with the business cycle. Real estate activity responds to
both long-term and short-term stimuli. The long-term cycle is a function of changes
in the characteristics of existing employment, population, and income and shifts in
consumer preferences. The short-term asset market cycle is largely a function of the
availability of credit and the condition of the overall economy.
Levels of Market Analysis

The essential process of determining the appropriate level of market analysis to
adequately support the results of an appraisal echoes the process of determining the
scope of work of an appraisal assignment. Depending on the intensity of the research
and analysis necessary to address the appraisal problem, market analysis can focus on
general market information about a property type or a defined area, or, with the addi-
tion of marketability analysis, it can focus on a specific property in a defined area.
The manner in which subject demand is analyzed is the simplest way to char-
acterize a market analysis assignment because estimates of demand are formulated
differently depending on the level of analysis required by the appraisal problem. In
some cases, demand may simply be inferred from published data and from current
and historical market conditions. In other cases, appraisers must gather and segment
extensive data and apply sound judgment to make detailed forecasts.
Both inferred analysis and fundamental analysis deal with the expected future de-
mand of users of the space over time. The term inferred demand analysis is used when
the analysis does not directly quantify the demand for a specific property. Instead,
the demand is inferred from general data and historical trends in the market. A more
detailed study of demand is identified as a fundamental analysis because it quantifies
the current and forecasted demand of potential users for the subject property.

Inferred analysis, which is sometimes called trend analysis, is descriptive and
relies on historical data to support future projections. The focus of inferred analysis
can be general, with selected comparable properties representing the larger market,
or more specific and include area-wide market data and subject-specific conclusions.
Whether the inferred analysis deals with the market in general or the marketability of
a specific property, the demand analysis rests on the baseline expectation that future
trends will replicate historical and current trends. Inferred analysis may also con-
clude that the future will be better or worse.
In the analysis of fundamental demand, appraisers identify the present demand
and forecast future demand based on a segmentation of broad demographic and eco-
nomic data to analyze the subject property’s specific market. Fundamental demand
analysis focuses on the economic forces that generate demand—what are known as
the fundamental forces of demand. The relationship of employment, population, and
income can be studied in inferred analysis, but an understanding of the relationships
among those forces is essential for fundamental analysis.
The occupancy of existing properties in the market is a good starting point as an
indicator of the total current demand. And, likewise, the performance of the property
being appraised can be a reliable indicator of current demand for existing proper-
ties in the market in the estimation of subject capture potential if the property has
been properly managed and has experienced stabilized occupancy. However, cur-
rent occupancy is not always equal to current demand in the market. In some cases,
government incentives or other influences may temporarily induce artificial demand,
which must be investigated to account for proposed properties and vacant land. For
example, if the current market has inadequate supply or the supply does not have the
real estate product with the features most desired by users of space, the amount that
actual demand exceeds the amount of occupied space in that market can be called
pent-up demand. The time frame of market analysis is not just the present market, it is
also is future-oriented. The future market can and will probably change, and, like-
wise, the occupancy forecast of the property being appraised is not automatically set
at the current occupancy level of that property or of its market. Table 15.2 lists the
indicators of demand relevant in both inferred analysis and fundamental analysis.
In inferred analysis, the reliability and relevance of market data for a specific
property tend to decrease as the geographic area examined in the demand analysis
is broadened. Clearly, current data on change in employment levels for the state has
less relevance than employment figures for a property’s immediately surrounding
area. Likewise, data on a related, but distinct, property type is not a reliable indicator
of demand for the property being appraised. For example, the analysis of inferred de-
mand for space in neighborhood shopping centers would not rely on the occupancy
levels in regional malls in the area as an indicator of demand.
Currently occupied space serves as an appropriate indicator of inferred demand
as long as there is no pent-up demand or artificially induced occupancy. Current net
absorption of new and vacant space on the market is the key consideration.
The levels of market analysis that can be performed cover a spectrum of increas-
ingly detailed methodologies.2 The practice of market analysis is commonly segment-
ed into four levels of progressive depth and complexity:
2. For a comprehensive discussion of the various levels of market analysis, see Stephen F. Fanning, Market Analysis for Real Estate, 2nd ed. (Chicago:
Appraisal Institute, 2014).
Market Analysis 281

• Level A
• Level B
• Level C
• Level D
In this organizational scheme, Level A and Level B studies typically involve inferred
demand analysis while Level C and Level D analyses look at fundamental demand.
Table 15.3 summarizes the distinctions between inferred analysis and fundamental
demand analysis and indicates the levels of analysis associated with each.
Determining the level of market analysis appropriate to a specific appraisal as-
signment is a scope of work issue. The length of the forecast required is not the major
criterion involved in the decision. Rather, the primary issues in determining the level
of study are the prevailing market conditions at the time of the appraisal and the
future expectations of the market, the current and expected future competition, and
the complexity of the property being appraised. For example, a stable market that
has a history of not fluctuating greatly is easier to analyze than a volatile market. In a
stable market with no overbuilding or shortage of supply evident, an inferred market
analysis might be acceptable. Similarly, a large or complex property often requires a
higher level of market analysis no matter what the overall market conditions have
been. For instance, a market analysis for a large property that combines multiple uses
would generally require a fundamental analysis. Note that the level of study criteria
is not based on current conditions as much as what is expected in the future. For
example, a fully leased office building in an unstable market might require a Level C
study due to future uncertainties, while the same type of fully leased office building
in a stable market might only require a Level A or B study.
In general, a Level A, B, or C market analysis is an adequate scope of work for
most appraisal assignments. Labor-intensive Level D market analyses—which, like
Table 15.2 Indicators of Demand for Proposed Properties and Vacant Land
Area Examined Indicators of Demand
Competitive properties Current and historical vacancy rates
Trends in current and historical rental rates
Market area Current and historical vacancy rates for existing competitive space
Trends in current and historical rental rates for existing competitive space
Construction activity—competitive space
Preleasing of planned space and space under construction
Current condition and historical changes in fundamental forces of demand (employ-
ment, population, and income)
Macroeconomic area Current and historical vacancy rates for existing property types
Trends in current and historical rental rates for existing property types
Construction activity—property type
Preleasing of planned space and space under construction
Current condition and historical changes in fundamental forces:
• Employment levels and foreclosure rates
• Residential occupancy and foreclosure rates
• Income levels and consumer spending

Table 15.3 Levels of Market Analysis in Appraisal
Inferred Demand Analysis Fundamental Demand Analysis
Level of Analysis A B C D
Inferred subject attributes Quantified subject attributes
Inferred locational determinants of use and Quantified and graphic analysis of location
marketability by macro analysis determinants of use and marketability by macro
and micro analysis
Inferred demand from general economic base analysis Inferred demand derived through original economic
conducted by others base analysis
Demand inferred from selected comparable sales or Forecast demand by subject-specific market segment
leased properties and demographic data
Supply inferred from selected comparable listings Supply quantified by inventorying existing and
forecasting planned competition
Inferred market equilibrium, highest and best use, Quantified
and capture conclusions • Market equilibrium
• Highest and best use
• Timing—quantified capture forecast
Emphasis is on Emphasis is on
• Instinctive knowledge • Quantifiable data
• Trend analysis of historical data and selected • Forecast specific subject data
comparable properties
• Judgment within data parameters • Judgment within data parameters
Source: Stephen F. Fanning, Market Analysis for Real Estate, 2nd ed. (Chicago: Appraisal Institute, 2014), 21.
Level C analyses, include the marketability analysis step—typically focus on the indi-
viduals behind the economic and demographic characteristics studied. Although ap-
praisers do not usually need to perform a Level D market analysis in assignments for
valuation purposes, they may use some techniques associated with Level D analysis
in a Level C market analysis. Table 15.4 illustrates the tasks involved in the various
levels of market analysis, and Table 15.5 summarizes the distinctions between levels.
Figure 15.5 illustrates the spectrum of market studies in typical appraisal assign-
ments. A Level A inferred demand analysis would only be appropriate when the
subject property is relatively simple and small for the market and the market itself is
stable. In other words, the conditions fit all the criteria for Level A analyses. A single
factor listed under the Level B criteria would raise the level of analysis necessary, and
two or more of those factors would likely increase the level of analysis to Level C.
The scope of work may be even higher for the market analysis of speculative devel-
opment or of improved properties in transition because of the significant complexity
of the properties involved and the uncertainty inherent in a particular market sce-
nario (i.e., the volatility of a market in transition).
Other factors considered in the determination of the appropriate level of market
analysis include the needs of the client and any requirements of professional stan-
dards for the specific assignment. A client’s informational needs and tolerance of risk
can influence the depth of market analysis desired, which could be well beyond what
might be required by professional standards for the particular appraisal assignment.
Market Analysis 283

Table 15.4 Partial List of Examples of Work Items in Various Levels of Market Analysis
Level of Study
Work Item A B C D
Property Analysis
General description ✓ ✓ ✓ ✓
Comparison to comparable properties ✓ ✓ ✓
Rating compared to industry standards ✓ ✓
Location Analysis
General description—city and neighborhood ✓ ✓ ✓ ✓
Specific analysis of site linkages ✓ ✓ ✓
Specific analysis of urban growth determinants ✓ ✓ ✓
Detailed competitive location rating ✓ ✓
Detailed probable future land use analysis ✓
Demand Analysis
General evidence of demand by sales/leasing activity ✓ ✓ ✓ ✓
General city growth trends ✓ ✓ ✓ ✓
Analysis of overall market absorption from secondary data ✓ ✓ ✓
Demand forecast by specific projections of population, employment, and income ✓ ✓
Demand forecast for subject market segment ✓ ✓
Direct attitudinal survey of target market ✓
Competitive Supply Analysis
Vacancy rates for selected comparable properties ✓ ✓ ✓ ✓
Vacancy rate from secondary data—broad market surveys ✓ ✓ ✓
Field research on all competitive properties ✓ ✓
Research on proposed properties—field inspection, building permit analysis,
Identification of potential sites ✓ ✓
Detailed competitive amenities rating ✓ ✓
Direct interview structural survey of developers ✓
Market Condition Analysis
General inference from broad data ✓ ✓ ✓ ✓
Secondary data analysis of occupancy and rent trends ✓ ✓ ✓
Specific submarket calculations of demand and supply ✓ ✓
Capture Analysis
General inference from select comparable properties ✓ ✓ ✓ ✓
Inference from survey of all competition ✓ ✓ ✓
Quantifiable capture potential rating of competition ✓ ✓
Highest and Best Use Conclusion and Marketability or Timing
Vacant Land
Probable use and timing but no specific timetable for development ✓
Generalized land use plan
Probable use supported by present value analysis ✓
Timing supported by secondary data ✓ ✓ ✓
Specific land use plan
Probable use supported by present value analysis ✓ ✓ ✓
Land plan drawn to site ✓ ✓
Timing based on residual demand, feasibility rent, and competitive rating analysis ✓ ✓
Cost estimate for subject development ✓
Value impact analysis of alternative marketing/development strategies ✓
Improved Properties
General ad hoc judgments ✓
NOI projection supported by performance of selected comparable properties ✓ ✓ ✓ ✓
Use, timing, NOI projection supported by analysis of secondary data ✓ ✓ ✓
Capture rate/NOI projection supported by residual demand of market segment
and competitive ratings ✓ ✓
Risk analysis of NOI forecast ✓
Value impact analysis of alternative marketing and development strategies ✓
Source: Stephen F. Fanning, Market Analysis for Real Estate, 2nd ed., 26.

Table 15.5 Summary of Levels of Market Analysis in Appraisal
Category Level A Level B Level C
Property analysis Descriptive Descriptive plus comparison Quantify marketability factors
Location analysis Generic description Description and analysis of Quantify location factors in
subject specific linkages/ relationship to growth trends
urban growth, etc. impacting subject and its
completion
Legal Descriptive Subject specific analysis Quantify impact and
probability for change
Market delineation Macro general Subject specific identified Subject specific identified on
map, and consumer
characteristics quantified
Economic demand Generic description of Inferred by competitive set Quantify demand sources
broad market area and and subject submarket area
selected comparable trends
properties
Competitive supply Generic description Submarket specific Inventory all competition
overall amount
Market condition Generic city-wide Specific trend analysis Quantify specific demand with
subject specific competition
Marketability analysis General inference from Pro rata share and Quantify competitive rating
(subject capture) selected comparable competitive set analysis with all competition
properties
The studies are cumulative. For example, a Level C study includes Level A and B studies.
Figure 15.5 Reliability Continuum

Level A Level B Level C
Simple property Complex property Complex property

Small property 3 of 3 Large property 1 of 3 Large property 2+ of 3
Stable market Volatile market Volatile market
Timing is now. Timing is probably now. Timing is an issue.
Economic Base Analysis

As defined in Chapter 9, the economic base of a community is the economic activity (or activities) that
allows local businesses to generate income from markets outside the community’s borders. Economic base
analysis is a survey of the industries and businesses that generate employment and income in a community
as well as a study of functions of employment such as the rate of population growth and levels of income,
which—as mentioned earlier—are drivers of demand.
Economic base analysis is used to forecast the level and composition of future economic activity and to
test the reasonableness of the forecasts of others. In Level D market analysis, the relationship between basic
employment (which brings income into a community) and nonbasic employment (which provides services
for workers in the basic employment sector) is studied to predict population, income, or other variables that
affect real estate values or land use.
Market Analysis 285

Employment figures serve as a proxy for income in economic base analysis. Basic employment industries
provide the economic foundation for a community by producing goods and services that can be exported to
bring money into the local economy. Although some segments of the service sector can be considered basic
economic activities, most service industries are nonbasic because the service provided and the income
generated remain within the community’s borders. Growth in basic employment can serve as evidence of
changes in population levels, household income, or other economic factors influencing land use and real
estate value.
Often the structure of a community’s business sector is discussed using the North American Industry Clas-
sification System (NAICS) developed and used by the US Bureau of the Census. Government publications
such as the Census of Retail Trade use NAICS codes in describing the composition of trade in a metropolitan
statistical area. A sample from the NAICS codes is shown below.
2017 NAICS Definition

† = Canadian, Mexican, and United States industries are comparable.
Search results for: 31
Number of records found: 652
31-33 Manufacturing†
311 Food Manufacturing†
3111 Animal Food Manufacturing†
31111 Animal Food Manufacturing†
311111 Dog and Cat Food Manufacturing
311119 Other Animal Food Manufacturing
3112 Grain and Oilseed Milling†
31121 Flour Milling and Malt Manufacturing†
311211 Flour Milling
311212 Rice Milling
311213 Malt Manufacturing
31122 Starch and Vegetable Fats and Oils Manufacturing†
311221 Wet Corn Milling
311224 Soybean and Other Oilseed Processing
311225 Fats and Oils Refining and Blending
31123 Breakfast Cereal Manufacturing†
311230 Breakfast Cereal Manufacturing
3113 Sugar and Confectionery Product Manufacturing†
31131 Sugar Manufacturing†
311313 Beet Sugar Manufacturing
311314 Cane Sugar Manufacturing
31134 Nonchocolate Confectionery Manufacturing†
311340 Nonchocolate Confectionery Manufacturing
31135 Chocolate and Confectionery Manufacturing†
311351 Chocolate and Confectionery Manufacturing from Cacao Beans
Source: 2017 NAICS, available online at www.census.gov
In practice, the process of economic base analysis is straightforward:

1. Identify the geographic extent of the local economy.
2. Identify the basic industries in the local economy.

3. Estimate total basic employment for the community.
4. Calculate the economic base multiplier and other ratios linked to employment.
5. Forecast future basic employment.
6. Forecast future total employment and any other factors linked to employment.
Established techniques for identifying basic industries in a particular local economy include the judgment
approach, the direct survey approach, the location quotient (LQ) approach, and the minimum requirements
approach.*
Surveys and other data-gathering techniques employed in economic base analysis generate primary data
that can be used in other types of market analysis.
* Examples of the application of economic base analysis can be found in Stephen F. Fanning, Market Analysis for Real Estate, 2nd ed.
(Chicago: Appraisal Institute, 2014), 105-128.
Market Analysis 287

Applications of 16
Market Analysis
Level B and Level C market analyses are the processes most commonly used by ap-
praisers in the valuation process. The choice of Level B or Level C analysis depends on
whether inferred analysis or fundamental analysis better suits the scope of work of the
assignment. For example, a Level B marketability analysis may not be appropriate for
a volatile market because the results of historical trend analysis may not be reliable if
the market is changing quickly and without a discernible pattern. In that situation, an
appraiser would need to perform a more extensive Level C analysis of the fundamen-
tal forces of demand (including marketability analysis) in order to be able to provide
the client with credible results. Figure 16.1 illustrates the framework of the six-step
process in detail, enumerating the interim steps in the application of the technique.
As a review, in property productivity analysis (Step 1), the characteristics of the
subject property are analyzed to determine the competitive strengths and weaknesses
of that property. In Step 2, the competitive market area is delineated, based on the
geographic area where the subject property’s competitors are located. In Step 3, cur-
rent demand for space of the subject property’s type is estimated, and predictions are
made regarding future changes in demand. In Step 4, the existing supply of the prop-
erty type is identified, and predictions are made regarding the likely change in supply.
In Step 5, supply and demand are compared both now and in the future, and con-
clusions are drawn regarding current market conditions and the likely change in market
conditions going forward. In a fundamental demand analysis, residual demand is typi-
cally calculated, which is an estimate of the net amount (positive or negative) of new
supply that the market can support. In an inferred analysis, supply and demand are not
quantified, so Steps 3, 4, and 5 of the six-step process are sometimes completed more or
less simultaneously. Current and future market conditions are inferred from other data
rather than calculated directly. For example, historical construction trends may be used
as an indication of supply in the market rather than a forecast of new construction.
Finally, in Step 6—the marketability analysis step—appraisers can judge the
likely performance of the property being studied by (a) comparing productive at-
tributes of the subject property to those of competitive properties and (b) considering
Figure 16.1 The Six-Step Market Analysis Process
Step 1. PROPERTY PRODUCTIVITY ANALYSIS (Determine the Product)
A. Physical attributes
B. Legal and regulatory attributes
1. Private
2. Public
C. Location attributes
1. Identification of economic attributes - the association between land uses and their linkages
2. Identification of the movement of demand in relation to the direction of urban growth
Step 2. DELINEATE THE MARKET (Determine the Market)
A. Market area delineation concepts
1. Identification of demand sources and their location
2. Area over which substitute properties tend to compete with the subject
B. Consumer profile concepts
1. Identification of characteristics of most probable user
2. Segmentation of consumer groups
Step 3. DEMAND ANALYSIS (Measure Demand)
A. Inferred demand projection
Make a projection of demand based on historical growth and absorption data
B. Fundamental demand forecast
Submarket-specific demand forecast
Major demand drivers
1. Population creates households.
2. Income creates retail buying power.
3. Employment creates office and industrial users.
Step 4. SUPPLY ANALYSIS (Measure Competition)
A. Existing stock of competitive properties
B. Properties under construction
C. Potential competition
1. Proposed construction
2. Probable additional construction
D. Attributes and characteristics of competitive properties
1. Economic and financial
2. Locational
3. Site
4. Structure
Step 5. RESIDUAL DEMAND ANALYSIS (Compare Supply and Demand)
A. Residual demand analysis* (compare supply to demand over time)
B. Ratio of supply to demand (potential market occupancy)
C Market cycle concepts (analyze the interaction of supply and demand)
Step 6. SUBJECT CAPTURE ANALYSIS (Marketability Analysis Conclusions)
A. Inferred capture methods
Comparison of subject to general market indicators
• Comparable property data
• Secondary data surveys and forecasts
• Subject historical performance
• Local economic analysis
• Other
B. Fundamental capture methods
Estimate subject capture potential of fundamental demand forecast by methods such as
• Share of market
• Adjust by quantifiable rating techniques
• Subject historical capture rate
• Other
C. Reconcile subject capture indications derived by analysis of inferred and fundamental methods (market penetration concepts)
USE OF STUDY PROCESS (SIX-STEP) CONCLUSIONS
• Economic demand data for financial testing of highest and best use alternatives
• Economic demand data for the valuation models
* In economics, the term marginal demand refers to the change in demand for a product or service in response to a specific change in its price.
In that context, a marginal demand analysis could study, for example, how much demand for apartment units would increase in response to a
specific reduction in rent. That is a different analysis than described here. To avoid confusion, this text uses only the term residual demand analysis,
although appraisers sometimes use the term marginal demand analysis to mean the same thing.
Source: Stephen Fanning, Market Analysis for Real Estate, 2nd ed. (Chicago: Appraisal Institute, 2014), 15.

the changes in market conditions, demand, and competitive supply at the present
time and in the future. A property’s most probable uses are determined on the basis
of the physical, legal, and locational attributes (Step 1). If multiple uses are probable,
then Steps 2 to 6 would have to be repeated for each alternative use as input into the
financial analysis of alternatives in highest and best use analysis.
The examples of Level B and Level C market studies in this chapter illustrate the
interim steps appropriate for specific situations and provide information about con-
siderations relating to other property types at each step of the market analysis process.
Level B Inferred Demand Analysis

Real estate developers often want to know how many homes they can build in a subdi-
vision, what prices they could expect to receive for those properties, and the timing of
sales over an anticipated absorption period. A Level B marketability analysis would be
appropriate for a relatively large and simple property in a stable and predictable market.
For example, consider a proposed subdivision of one-unit homes in a suburban
location. In the years prior to financial crisis of 2008, many US markets saw a dramat-
ic increase in the number of lots being developed, which was a sign of market insta-
bility. The following years were marked by severely overbuilt and relatively inactive
residential markets and precipitous declines in prices, which were partly the result
of inadequate marketability analysis when the subdivisions were being planned and
funded. Throughout this cycle, Level C fundamental demand analysis was often
necessary to make a reliable absorption forecast for a subdivision. In a more typical
and stable market, however, absorption of proposed residential subdivisions is more
predictable, and a Level B market analysis may be adequate in many cases.
A proposed subdivision of one-unit homes located in a stable market will be used
as an illustrative example in this discussion of Level B market analysis.
Property Productivity
In all market studies, appraisers analyze the physical, legal, and locational character-
istics of the property being studied. In the case of a proposed suburban residential
subdivision, linkages to major employers and amenities and what is known as resi-
dential situs would be major locational considerations.1 Other physical characteristics
include the size and shape of the lots, topography, soil quality, orientation, stage of
development, and features of the improvements. Legal characteristics that might af-
fect value would include local zoning ordinances, building codes (e.g., local changes
to higher energy efficiency standards), the influence of a homeowners association,
property taxes, and any local codes, covenants, and restrictions.
Market Area Delineation

In the marketability analysis of the proposed subdivision, an appraiser would define
and delineate the market area of the property being studied as well as the competi-
tive market area based on the location of housing that would appeal to the same
consumers as the subject property. Also, the profile of the most likely users, either
renters or buyers in the market area, would be determined.
1. The concept of situs relates to the movement between centers of economic activity and the accessibility of those locations. For a detailed discus-
sion of situs, see Stephen Fanning, Market Analysis for Real Estate, 2nd ed., and Richard B. Andrews, Urban Land Economics and Public Policy
(New York: The Free Press, 1971).
Applications of Market Analysis 291

Property Productivity Analysis for Other Property Types
Property Type Considerations in Property Productivity Analysis
Existing apartment complex • Design and appearance of the property
• Number, size, and mix of units
• Site improvements and amenities (in units and for complex as a whole)
• Parking
• Complex amenity features such as workout rooms, wifi, meeting rooms, etc.
• Zoning (particularly the possibility of a zoning change for potential con-
dominium conversion)
• Infrastructure
• Public planning for growth
• Natural features and land use trends
• Linkages to major employers and amenities
• Externalities (busy street, noise, etc.)
Office building • Building design and construction materials
• Signage
• Exterior lighting
• Street layout
• Utilities
• Parking
• Lot and building lines
• Landscaping and grading
• Office space layout
• Tenant finish
• Floor sizes
• Stairways, corridors, and elevators
• Electrical system and Internet connectivity
• Heating, ventilation, and air-conditioning
• Amenities
• Security
• Building management and tenant mix
To analyze the characteristics of likely users of the specified housing units, a con-
sumer profile describing income levels, household size, age, and preferences would
be developed. The market area of potential users could be defined in terms of
• Time-distance relationships, e.g., the commuting time to employment centers and
support facilities
• Social or political boundaries (cities and neighborhoods, school districts, voting
precincts)
• Man-made or natural boundaries (major thoroughfares, physical barriers such as
rivers, lakes, and mountains)
• The location of competitive housing
Market area boundaries are typically the perimeter of a geographic area within
which (a) similar dwelling-unit styles are present, (b) dwellings of similar age, size,

Property Productivity Analysis for Other Property Types (continued)
Property Type Considerations in Property Productivity Analysis
Hotel • Size
• Room rate structure
• Overall decor and physical appearance
• Quality of management
• Chain affiliation
• Quality and character of the market area
• Facilities and amenities offered
• Revenue per available room (RevPAR), which is a common unit of comparison
used in the lodging industry to compare the income of competing facilities
Specific Locational Considerations
• Airport hotels and highway-oriented hotels cater to transient guests.
• Center city hotels draw both tourists and business travelers.
• Hotels in suburban locations often rely on adjacent commercial or industrial
businesses.
• Convention center hotels or resort properties are themselves the destina-
tion rather than any nearby land use.
Industrial property • Size (and land-to-building ratio or floor area ratio)
• Ceiling height
• Loading capacity (docks and doors)
• Circulation and parking
• Climate control
• Percentage of office space
• Automated operations (including the use of robotics and other evolving
technologies)
• Utilities
• Security
• Building management and tenant mix
and general condition are present, (c) a generally similar price range for housing ex-
ists, (d) the incomes of the resident households are somewhat similar, and (e) land use
is relatively similar. However, the area may contain noncompetitive properties as well.
Inferred Demand Projection

In an inferred analysis, demand might not be quantified as a specific number of
square feet or units. Instead, demand conditions are inferred from available data
sources. Any published studies relating to the pertinent market can be important
considerations. For a residential subdivision, major housing markets often have quite
detailed reports available that provide construction and sales statistics subdivision
by subdivision, along with summary statistics by unit size and type, price range,
and geographic submarket. In smaller markets, published studies are less detailed
or nonexistent, so appraisers must look to other sources to analyze demand. It is not
adequate to simply quote statistics. A Level B marketability analysis should include
an analysis of trends and a projection of changes in market conditions. If economists

Market Delineation for Other Property Types
Property Type Considerations
Existing apartment complex The boundaries of the market area for an existing apartment are based on
• time-distance relationships—the commuting time to employment centers and
support facilities
• social or political boundaries—school districts, voting precincts
• man-made or natural boundaries—major thoroughfares, physical barriers
• the location of competitive housing
Office space demand The market area for an office building is generally diffused into submarkets over
a broad metropolitan area, with law firms and financial institutions often seek-
ing space in prestigious, centrally located buildings, while businesses providing
other types of services may prefer suburban offices with ample parking facilities
and reasonable rents.
Hotel demand The market area for a hotel does not necessarily rely on households in nearby
communities to generate demand. Instead, linkages to sources of visitations in the
area can be more significant than the characteristics of the surrounding neighbor-
hood. Hotel development often occurs in clusters, and the emergence of a new
cluster nearby can have an impact on the competitiveness of existing properties.
Industrial property Established trade routes can define the boundaries of the competitive market
for multitenant industrial space. Because warehouses and distribution centers
must be close to major highways or railroad lines, industrial development will
tend to cluster around those features, especially major freeway interchanges
in centrally located states where a large percentage of the region’s or even the
country’s population can be within a day’s drive.
or other experts have made predictions regarding household formation or hous-

ing demand, those should be referenced and summarized. (If the data points to a
substantial change in market conditions, it may be necessary to complete a Level C
fundamental analysis, to better predict future market conditions.)
The resale market for comparable properties in the competitive market can serve
as an indication of market demand for units in the subject property. Comparing the
resale market for the entire community with the strength of the competitive market
can indicate whether a Level B analysis will be adequate. If the competitive market
area is weak while the number of households in the entire community is growing,
or the household location is shifting in the community, then a more detailed analy-
sis might be necessary. Data analyzed in Level B analyses is largely obtained from
secondary sources, e.g., the local multiple listing service, published reports, or local
real estate agents.
The general analysis of subdivisions competitive with the subject property leads
into an investigation of the performance of the subject property’s primary competi-
tion. The absorption of competitive properties is an important indicator used in Level
B marketability studies. Unlike most data in the other interim steps in the analysis of
inferred demand, the data used in the identification of the performance of the subject
property’s primary competition is primary data compiled by the appraiser. Informa-
tion about competing properties that may be gathered includes
• Reputation and track record of the project developer
• Total number of lots

• Type of project (e.g., infill or new growth area)
• Age of project
• Identification of finished product
• Absorption summary
• Special amenities and advantages or disadvantages
The measurement of current demand in a Level C marketability analysis would
differ from this Level B analysis in that this step in a Level C analysis would include
quantified forecasts of demand (lot or unit sales) based on employment, income, and
households. Nevertheless, a Level B marketability analysis could include inferences
drawn from employment, income, and population statistics. A change in employ-
ment or a change in the rate of household formation likely implies a change in hous-
ing demand. A change in household income could imply a shift in demand from one
housing type or economic segment to another.
Inferred Demand Forecast for Other Property Types

Property Type Considerations in Analysis of Inferred Demand
Existing apartment complex • General growth trends
• Apartment construction trends (note that significant construction can indi-
cate demand or could indicate a current or approaching oversupply)
• Historical vacancy rate and absorption figures
• Trends in effective market rental rates
Hotel demand • Travel and tourism data
• Hotel employment data and convention center activity
• Office space absorption and employment statistics—particularly regarding
wholesale and retail trade, services, and the financial, insurance, and real
estate (FIRE) sector
• Occupancy rates at competitive lodging facilities in the subject property’s
class and market area

Market supply can decrease as a result of demolitions or conversions to other uses.
Market supply can increase as a result of conversions or, most typically, from new
construction. In an inferred analysis, supply might not be quantified as a specific
number of square feet or units. Still, a credible Level B marketability analysis must
include consideration of the likely trend in supply. In the case of a residential subdi-
vision, if the rate of home construction increases without a corresponding increase
in demand, market conditions will decline. If demand remains constant but the rate
of construction slows, for example, due to a decline in finished lots or development
land, the market will become tight and prices will increase.
For an inferred analysis of a residential subdivision, the sources of supply data
are similar to the sources of demand data. In major housing markets, published
studies may include excellent information regarding the amount of new construction
broken down by unit size and type, price range, and geographic submarket. Munici-
palities can generally provide up-to-date permit data, although that information may

not be adequately disaggregated to allow for a refined analysis of a particular market
segment. Most inferred analyses include a compilation of construction data from the
most directly comparable and competitive subdivisions.
Some other factors that may influence potential supply include
• Availability and price of vacant land
• Cost and availability of construction materials
• Availability of desired product features
• Availability of construction loans and financing
• Effect of building codes, zoning ordinances, and other regulations on construction
This step in the analysis process also includes consideration of the timing and
competitive position of the future competition. In distressed markets, such as the
many overbuilt residential markets created by the subprime mortgage crisis, the
amount of competitive supply may be so far out of equilibrium that many years
would be required to absorb the existing excess supply at historical rates, barring
some external influence like the demolition of existing houses for redevelopment to
some other use. In those cases, the market may be stable but not considered predict-
able enough for inferred demand analysis to be meaningful. Therefore, a Level C
market analysis might be necessary to provide credible assignment results.
Competitive Supply Analysis for Other Property Types

Property Type Considerations in Analysis of Competitive Supply
Office building Important characteristics of competing properties:
• Size (gross building area or rental area)
• Age
• Vacancy level
• Access
• Parking
• Tenant quality
• Building management
• Building quality and condition
• Amenities
• Support facilities
Industrial property Important characteristics of competing properties:
• Size, particularly in relation to other industrial buildings
• Age and condition
• Vacancy level
• Access
• Building management and tenant quality
• Building quality
Residual Demand Analysis (Market Conditions)

In a fundamental analysis, the estimate of quantified demand is compared to quanti-
fied supply, either as a ratio or as a residual demand calculation. That refined calcu-

lation is not typical in an inferred analysis. Nevertheless, a Level B market analysis
does include a comparison of demand conditions (Step 3) to supply conditions (Step
4) and a conclusion regarding current overall market conditions and a projection
of future market conditions. Inferred analysis works best when market conditions
are expected to remain relatively stable. If supply, demand, or both are expected
to change substantially, a Level C market analysis might be necessary to provide
credible assignment results. As mentioned, the demand analysis (Step 3), the sup-
ply analysis (Step 4), and the conclusion of market conditions (Step 5) are sometimes
completed more or less simultaneously in an inferred analysis. The conclusions gen-
erally include a statement about where the market is in relation to theoretical equilib-
rium, and often include a statement identifying the current stage of the market cycle
(e.g., expansion, contraction, recession, recovery).
Subject Capture Analysis (Marketability Conclusions)

In the final step of the marketability analysis process, appraisers consider current and
anticipated market conditions (Step 5) and the subject property’s relative competi-
tive strength (Step 1) to make conclusions regarding the performance of the subject
property. For a residential subdivision, those conclusions would include the rate of
sales over the sell-out period and the trend in lot or home prices. Those conclusions
are necessary for the highest and best use analysis and are an important component
of the three approaches to value.
Consider an appraiser who is analyzing a proposed residential subdivision and
finds three competitive subdivisions in the subject property’s market area. Over the
past year, these subdivisions have had average sales rates of three lots per month,
five lots per month, and seven lots per month. Simply using the average sales rate
for the three competitive subdivisions of five lots per month as the estimated absorp-
tion rate for the subject property would most likely be incorrect unless the market is
stable and the competitive strength of the subject property is entirely average. The
conclusions of the inferred analysis would be that historical absorption by competing
subdivisions is three to seven lots per month and that supply is increasing.
Level C Fundamental Demand Analysis

The distinguishing characteristic of fundamental analysis is a quantified estimate
of demand, supply, and residual demand. In Level C market analyses, current and
future demand estimates are tied to analysis of the fundamental forces of demand
(employment, population and income). It should also be recognized that Level C
analysis is a cumulative study, building on the results of Level A and B analyses with
the addition of more detailed data gathering and analysis.
The following example outlines the six-step process, including a forecast of fun-
damental demand for the Level C market analysis of a community shopping center at
a specific site over a given period.
Property Productivity Analysis

Analysis of the physical, legal, and locational attributes of the property being stud-
ied and the competitive shopping centers in or near the subject property’s trade area
focuses on current industry (or market) standards. Retail properties can become out-

dated quickly as industry norms change. Particular attention is given to the following
attributes of the subject site and improvements:
• Land-to-building area ratio and availability of expansion land
• Building area
• Parking adequacy
• Frontage, visibility, and depth
• Topography
• Utilities
• Landscaping
• Site design and layout
• Accessibility
• Amenities
• Gross building area and gross leasable area
• Store sizes
• Store width and depth
• Building design and layout
• Signage
• Service facilities and space
Tenant mix and related characteristics influence market appeal as well.
Relevant legal characteristics of the subject property would include zoning and
use restrictions, long-term store leases that affect the marketability of the property,
and ground leases in place.
Unsurprisingly, locational factors are important for retail properties. The loca-
tional attributes that should be investigated include
• Land uses and linkages with the surrounding community
• Site location in relation to patterns of urban growth
• Proximity to competitive supply
The culmination of the location analysis is rating the macroeconomic location of the
subject property in comparison with the competition. Analysis of the macroeconomic
location would include consideration of the following:
• Proximity to households in the market area
• Proximity to new retail development
• Location in the path of growth, e.g., new or projected residential development
• Proximity to major roads, in terms of access and visibility
• Relative traffic counts
• Proximity to the market
• Size and drawing appeal of anchor stores
• Tenant mix and compatibility in the trade area
• Effective age and reputation of the properties in the retail cluster
• Special amenity features

In a Level C market analysis, the physical and legal characteristics of the subject
property and competitive nodes are rated against the market standard. The market
standard is the characteristic that space users consider to be typical or appropriate.
The use of rating grids formalizes the comparison process and helps appraisers iden-
tify functional obsolescence, select comparable sales, and identify influences on rent
and occupancy. In a rating table, scores and weights are assigned to various charac-
teristics, with the middle of the possible scores representing the market standard. The
difference between a property characteristic and the market standard is referred to
as competitive differential. The total of the weighted scores can be used to conclude the
relative competitive strength of the subject property.
A Level C market analysis might also include the use of mapping and other
graphic analysis tools to illustrate linkages (e.g., roads and utilities that influence the
movement of people, goods, services, and communication to and from the property
site) and patterns of urban growth that might affect the boundary of a market area.
Market Delineation
The geographic market area relevant in a Level C marketability analysis may differ
from the market area defined for a Level B analysis because the analysis of fundamen-
tal demand often requires a market area that aligns with the sources of specific data.
Effective analytical tools for defining the primary and secondary trade areas of
a shopping center have been objects of study for many years. The most commonly
used techniques include
• Trade area circles or drive-time maps, in which preliminary trade area boundar-
ies are adjusted for the specific geographic, demographic, and economic charac-
teristics of the community
• Gravitational models, a variation of trade area circles that takes into account the
effects of competition
• Customer spotting, a more detailed form of trade area circles in which actual
customer addresses are surveyed to determine distances and linkages
Forecast of Fundamental Demand

The estimate of current and future demand in a Level C marketability analysis is the
step of the process that departs the most from the scope of work of a Level B analysis.
A Level C marketability analysis forecasts an actual calculation of competitive demand
for the users of the space in the subject property. The Level C analysis is then recon-
ciled with the Level A and Level B analyses into a final demand forecast range. For ex-
ample, analysis of inferred demand for retail space may include study of the following:
• Economic base and city growth trends
• Citywide retail center occupancy
• Competitive center occupancy
Estimation of fundamental demand for retail space requires analysis of additional
market data, including the following:
• Number and size of households in the market area
• Average household income

• Percentage of average household income spent on retail purchases
• Percentage of retail purchases typically made at shopping centers of the subject
property’s type
• Percentage of purchases made at shopping centers of the subject property’s type
that is retained by centers in the primary trade area and leakage out to the sec-
ondary trade area
• Volume of sales per square foot of retail area required to support development of
a shopping center of the subject property’s type
• Normal (equilibrium) vacancy rate in the market
A step-by-step analysis of this data allows an appraiser to estimate the square footage
of demand for retail space in the primary market area, based on household incomes.
Other techniques can also be used to quantify demand, such as a ratio analysis
of the trade area in which the current amount of occupied retail square footage per
capita is compared to the future population forecast. The estimates of fundamental
demand from the various techniques are then reconciled with demand from inferred
analysis to provide final estimates of demand.

The measure of current competitive supply is based on a survey of shopping centers
that compete with the subject. The forecast of future competitive supply could be
compiled by identifying the amount of
• Existing square feet in competitive centers
• New square feet currently under construction
• Proposed properties in the planning and approval process and in the next antici-
pated market cycle
• Vacant sites available for development
The total forecast of competitive space is often based on assigning probabilities to
space under construction or in the planning and approval process. The probabilities
can be estimated by studying the proportion of historical proposals that resulted in a
completed project.
The supply of existing and anticipated competitive space would be rated accord-
ing to the following characteristics:
• Size
• Access and location
• Quality of merchandise
• Project amenities
• Reputation
• Rental rates
• Vacancy
• Tenant mix (with emphasis on anchor occupants)
This analysis of competitive supply should yield estimates of the square footage of
specific competition and a comparative ranking of the subject property.

Fundamental Demand Forecast for Other Property Types
(Over and Above Analysis of Inferred Demand)
Property Type Considerations in Analysis of Fundamental Demand
Single-unit residential subdivision • Current and projected population and households within the defined
market area
• Current and forecasted future ratio of owner-occupied households
• Household income and affordability limits to segment demand by
price range
• Housing-type preferences for segment households (ratio of house-
holds who choose detached housing versus townhouses, stacked
condominiums, or other)
Apartment complex • Current and projected population and households within the defined
market area
• Current and forecasted future ratio of renter-occupied households
• Household income and affordability limits to segment demand by rent
range
• Housing-type preferences for segment households (ratio of house-
holds who choose apartment units over other types of rental units)
Office building • Size of the workforce occupying office space
• Proportion of demand in the subject property’s competitive class
(e.g., Class A, Class B, Class C)
• Requisite space per worker
• Normal (equilibrium) vacancy rate
Hotel • Current demand (e.g., number of room nights)
• Segmentation of demand (commercial, meetings and groups,
leisure, etc.)
• Statistics and forecasts for drivers of each demand segment (e.g., busi-
ness statistics for commercial, tourism and travel statistics for leisure
• Segmentation of demand by property type (e.g., full service, limited
service, extended-stay.)
• Segmentation of demand by room rates
Industrial property • Employment in sectors using industrial space (e.g., manufacturing,
wholesale, retail, transportation, communications, or public utilities)
• Requisite space per worker
• Patterns and directions of industrial growth and development, which
often cluster along major highways and around intersections
• Statistics and forecasts for other drivers of demand; for example,
population growth and retail activity for warehouse demand
Residual Demand Analysis

In a Level C market analysis, the analysis of market conditions is facilitated by calcu-
lating residual demand, i.e., the demand that is not satisfied by available supply. In
other words, residual demand is the amount of undersupply (i.e., a negative number
in an oversupplied market). Residual demand is calculated by adjusting demand for
equilibrium vacancy and then deducting supply:
(Measured Demand)
Adjusted or Supportable Demand =
(1 - Equilibrium Vacancy Rate)

This adjustment accounts for the fact that a market needs a certain amount of vacant
space to operate in an orderly fashion.
The residual demand calculation in a fundamental analysis can be condensed to
five lines as illustrated in Table 16.1. In the calculation of residual demand, existing and
forecasted demand over the market cycle is compared with current and anticipated
competitive supply to predict the amount of oversupply or undersupply at various
points in time. Analysis of residual demand patterns allows appraisers to forecast the
pattern of changes in the market cycle, to estimate when additional space will be need-
ed in the market, and to determine the likely pattern of market rent. For example, the
figures in Table 16.1 relate to a market with a current supply of 712,400 square feet and
a current occupancy rate of 90.2%. A new shopping center of 90,000 square feet is ex-
pected to be completed within the next five years, which will significantly oversupply
the market and push the market occupancy rate down to about 86% by Year 5. Due to
a forecasted increase in demand, however, the oversupply will be filled by about Year
9 and the market will have a small undersupply by Year 10. With these calculations, an
appraiser could reasonably conclude that market rents are likely to be flat or decreasing
in the first five years but trend upward at some point in Years 5 to 10. Residual demand
(the difference between supportable demand and the supply of existing and anticipat-
ed retail space) would be the estimate of additional space needed in the market.
Another useful calculation in Step 5 of the six-step process is the ratio of demand
to supply, which is calculated simply as unadjusted demand divided by supply.
When there is no pent-up demand and no artificial demand, the ratio of demand to
supply is a measure of market occupancy.
Table 16.1 Residual Demand Calculations (Step 5)

L ine Current Year 5 Year 10
1 Current and forecasted demand (sq. ft.) 642,300 689,200 749,600
2 Adjustment for equilibrium vacancy [1 minus equilibrium vacancy rate] ÷ 0.92 ÷ 0.92 ÷ 0.92
3 Adjusted (supportable) demand [Line 1 ÷ Line 2] 698,152 749,130 814,783
4 Current and forecasted supply (sq. ft.) 712,400 802,400 802,400
5 Residual demand [Line 3 - Line 4] -14,248 -53,270 12,383
6 Ratio of demand to supply [Line 1 ÷ Line 4] 90.2% 85.9% 93.4%
Other inferred market condition tools include rent trend analysis, feasibility
rent analysis, and analysis of sales per square foot for individual stores. Rent trend
analysis investigates the direction of change in rent levels. For example, rents may be
rising at similar amounts as previous years, or rents may be increasing but not at the
same rate. Some real estate professionals believe that an increase in rent at a declining
rate is a sign of the peak of the market.
Sales per square foot in individual retail stores may indicate the performance
level of an existing shopping center, the center’s share of the market, and whether
there is opportunity for expansion. This data may be used to check the reasonable-
ness of the estimate of additional space demanded.

Vacancy in Residual Demand Studies
All real estate markets need some vacant space to allow space users to move in and move out and to accom-
modate anticipated increases in demand in the short term. Equilibrium vacancy is the vacancy rate when a
market is at equilibrium, with no upward or downward pressure on rents. The equilibrium vacancy rate, also
known as normal vacancy or natural vacancy, varies from market to market based on construction costs, land
availability, the rate of growth in demand, and other factors. If there is an undersupply in the market, residual
demand is the amount of new construction that can be supported. If there is an oversupply, an analysis of re-
sidual demand at various points in time can provide a prediction of when the market will return to equilibrium.
Subject Capture Analysis (Marketability Analysis Conclusions)

Subject capture is the amount or ratio of market demand a subject property is expect-
ed to capture. Subject capture analysis generally begins with an estimate of pro rata
share, which is then adjusted to account for the competitive strength of the subject
property relative to competitive retail centers. For example, suppose that the subject
property is a 90,000-square-foot retail center in the market outlined in Table 16.2.
Because the subject
property represents Table 16.2 Subject Capture
11.22% of market sup-
ply in Year 5—90,000 sq. Forecasted market demand in Year 5 689,200
ft. in the subject prop- Subject capture rate (103% of pro rata share) 11.56%
erty/802,400 sq. ft. in Subject capture (occupied sq. ft.) 79,672
the market—its pro rata Subject leaseable sq. ft. 90,000
share of demand in that Subject occupancy ratio 88.5%
year is also 11.22%. Sup-
pose also that property
productivity analysis (Step 1) and supply analysis (Step 4) show that the competitive
characteristics of the subject property are above average, and the appraiser concludes
that the property’s appropriate capture rate is 3% above the property’s pro rata share,
or 11.56% (11.22% pro rata share × 1.03). The subject property’s occupancy rate in Year
5 could therefore be forecast as indicated in Figure 16.1. Although the forecast of mar-
ket occupancy in Year 5 was just 85.9%, the forecast of occupancy for the subject prop-
erty specifically in Year 5 is 88.5% because of its superior competitive characteristics.
Because retail concepts can change quickly, subject capture is especially difficult
to forecast for retail properties. Therefore, it is often appropriate for good marketabil-
ity studies to include high-, mid-, and low-range forecasts to report the full range of
likely outcomes.

Highest and Best Use Analysis 17
The analysis of highest and best use can be thought of as the logical end of a spec-
trum of market analysis procedures, running from the study of a property’s mar-
ket area, through more detailed marketability studies into the financial analysis of
alternatives to determine the most profitable use, and finally to the reconciliation and
formal conclusion of highest and best use, the timing of that use, and the most prob-
able buyer. All these forms of analysis are interrelated processes that measure the
economic potential of alternative uses of real estate.
The essential components of the analysis of highest and best use are contained in
the following definition of the term:
The reasonably probable use of property that results in the highest value.
This simple definition will serve as a point of departure for examining the concept in
the rest of this chapter.
To be reasonably probable, traditionally a use must meet certain conditions:
• The use must be physically possible (or it is reasonably probable to render it so).
• The use must be legally permissible (or it is reasonably probable to render it so).
• The use must be financially feasible.
Uses that meet the three criteria of reasonably probable uses are tested for economic
productivity, and the reasonably probable use with the highest value is the highest
and best use.
Conceptually, the criteria of highest and best use are self-explanatory. That is,
physically possible uses are land uses that are not unworkable because of some limiting
physical characteristic of the land such as inadequate site size, odd shape, irregular
topography, or poor soil quality. For example, a steeply sloped site may limit the use
of the land to only a few possible alternatives. In contrast, a level plot of land with
good drainage, soil with adequate bearing capacity, and other physical characteristics
conducive to the construction of improvements would likely allow a developer to
build many different types of facilities.
Based on similar logic, legally permissible uses would conform to the land’s zoning
classification and local building codes along with any other relevant regulatory or con-
tractual restrictions on land use. The requirement for legally permissible uses eliminates
many possible uses because they would not be allowed with the zoning laws, subdivi-
sion covenants, deed restrictions, leases, or other contractual obligations of the property
owner. For example, the highest and best use of a site for development as a fast food
restaurant with dine-in facilities might be eliminated because the site is smaller than
the minimum size to meet the parking requirements of that use set by local regula-
The Difficulty of Defining Highest and Best Use

The definition of highest and best use has evolved over time to address the common understanding of the
topic. Traditionally, the explanation of the term has been more elaborate than the definition introduced in the
14th edition of The Appraisal of Real Estate. For example, earlier definitions of the term included ambiguous
language that has often been commented on but never defined, as seen in the entry for the term in the fifth
edition of The Dictionary of Real Estate Appraisal:
highest and best use
The reasonably probable and legal use of vacant land or an improved property that is physically possible, appropri-
ately supported, financially feasible, and that results in the highest value. The four criteria the highest and best use
must meet are legal permissibility, physical possibility, financial feasibility, and maximum productivity. Alternatively,
the probable use of land or improved property—specific with respect to the user and timing of the use—that is
adequately supported and results in the highest present value.
The precise meaning of “appropriately supported” has been debated in the appraisal literature almost since
the basic template of this definition of highest and best use was developed in the mid-1970s.
A streamlined definition was later developed for the Appraisal Institute course General Appraiser Market
Analysis and Highest & Best Use (2008), reducing the ambiguous language while eliminating direct reference
to the four traditional tests of highest and best use:
highest and best use
The reasonably probable use that produces the most benefits and highest land value at any given time.
In early editions, the International Valuation Standards had defined highest and best use in a similar
fashion as The Dictionary of Real Estate Appraisal, fifth edition. However, the 2017 edition of the standards
removed the definition and instead described highest and best use as “the use of an asset that maximises
its potential and that is possible, legally permissible and financially feasible” in the standards document’s
discussion of bases of value. (Section 30.4, General Standards—IVS 104)
The Uniform Appraisal Standards for Federal Land Acquisitions (most recently updated in 2016) defines
highest and best use as the “highest and most profitable use for which the property is adaptable and needed
or likely to be needed in the reasonably near future,” citing federal case law as a source. (Section 4.3)
Historically, other concepts have been championed as alternatives to the term highest and best use as
a description of what use of vacant or improved land should be analyzed, depending on the nature of the
appraisal assignment:
most probable use
1. The use to which a property will most likely be put based on market analysis and the highest and best use con-
clusion. The most probable use is the basis for the most probable selling price of the property.
2. Highest and best use in the context of market value.
(The Dictionary of Real Estate Appraisal, 6th ed.)
most profitable use
Highest and best use in the context of investment value.
(Real Estate Appraisal Terminology, rev. ed.)
Usage of most probable use in the appraisal literature has dropped significantly in the last 20 years, while
the alternative related to investment value, most profitable use, is now largely used in the context of valuation
for litigation purposes.

tions. However, as discussed later in this chapter, the reasonable probability of a zoning
change can be a consideration of potential land uses not allowed by current zoning.
The analysis of financial feasibility narrows the number of legally permissible and
physically possible uses down further through analysis of the economic character-
istics of the potential alternative uses. Economic demand for the subject property is
a requisite to the financial testing of alternative uses. Any uses that are not worth at
least what they cost to produce would be eliminated in the test of financial feasibility.
The remaining options are candidates for the test of maximum productivity, which
is the final—and deciding—criteria for the highest and best use of both the land as
though vacant and the property as improved.
Traditionally, to test alternative uses of a property in highest and best use analy-
sis, appraisers have analyzed the four criteria in the following order:
1. Legal permissibility
2. Physical possibility
3. Financial feasibility
4. Maximum productivity
The criteria of physical possibility and legal permissibility could be analyzed in either
order, but as a practical matter they both must be analyzed before the criteria of financial
feasibility and maximum productivity. A use may be financially feasible, but this is irrel-
evant if the land use is legally prohibited or physically impossible. Likewise, the analy-
sis of financial feasibility filters out uses that lack enough demand in the marketplace to
compete for consideration as the use with the highest value, and therefore the analysis
of financial feasibility necessarily precedes the analysis of maximum productivity.
Land as Though Vacant and as Improved

A fundamental concept of highest and best use is the idea that highest and best use is
viewed from two perspectives:
• The use of the real estate based on the presumption that the parcel of land is
vacant or can be made vacant by demolishing any improvements (i.e., as vacant
or as if vacant)
• The use that should be made of the real estate as it exists (i.e., as currently im-
proved or as if improved as proposed)
The highest and best use of land as though vacant and the highest and best use of the
real estate as improved are connected but distinctly different concepts.
The analysis of land as though vacant focuses on alternative uses of the land, with
appraisers analyzing each reasonably probable use. In the analysis of highest and best
use of land as though vacant, appraisers seek the answers to several questions:
• Should the land be developed or left vacant?
• If left vacant, when would future development be financially feasible?
• If developed, what kind of improvements should be built?
In contrast, when appraisers analyze the highest and best use of the real estate as
improved, the focus on alternative uses considers three possible actions related to the
current improvements:

1. Retain the improvements.
2. Modify the improvements in some way, such as conversion, renovation, or alteration.
3. Demolish the improvements and redevelop the land.
The analysis of the highest and best use of the real estate as improved answers a dif-
ferent question than the analysis of the land as though vacant:
• Should the existing improvements on the property be maintained in their current
state, should they be altered in some manner to make them more functionally
efficient, or should they be demolished to create a vacant site for a different use?
• If renovation or redevelopment is warranted, when should the renovations or
redevelopment occur?
In some situations, a property may be subject to restrictions (e.g., historic preserva-
tion) that prevent the improvements from being demolished. In this case, the highest
and best use is limited by the restriction. A lease of the property may also restrict
highest and best use alternatives because the lease will allow the tenant to control the
land use for the term of the lease.
Legally Permissible Uses of Land as Though Vacant

Zoning, building codes, private restrictions, historic district controls, and environ-
mental regulations govern the uses to which land can be put, and those restrictions
may preclude many potential land uses. To analyze legal permissibility, an appraiser
determines which uses are permitted by current zoning, which uses could be permit-
ted if a zoning change were reasonably probable, and which uses are precluded by
private restrictions on the site, depending on the intended use of the appraisal.
Private restrictions and deed restrictions such as conservation and historic preser-
vation easements as well as long-term leases are typically registered on the title, and
those legal characteristics of the property may prohibit certain uses or specify building
setbacks, heights, and types of materials. If deed restrictions conflict with zoning laws or
building codes, the more restrictive guidelines usually prevail, but this may pose a legal
question that must be obtained from a professional with the appropriate legal expertise.
A long-term land lease may affect the highest and best use because lease provi-
sions can limit the type and duration of use over the remaining term of the lease. For
example, if a property is subject to a land lease that has twelve years remaining on
the term, it may not be economically feasible for the lessee to demolish the existing
building and then construct and move into a new building with a longer remaining
economic life because the right of possession of the building reverts to the lessor at the
end of the lease. In that case, the determination of highest and best use of the property
as leased is influenced by the lease’s effect on the utility of the land over the remain-
ing lease term. As another example, some medical office buildings that are built on
hospital campuses have covenants that state that owners of the property are restricted
to only doctors who have privileges at that hospital. This sort of private restriction can
reduce the pool of possible buyers of this sort of property to a few or none. That is, the
current owners may be the only possible users. In contrast, some legal issues can be
positive influences that enhance a property. For example, a cross easement for access or
parking may increase the marketability of some alternative use options of a given site.
In addition to analyzing zoning and private restrictions as part of the test of
the legal permissibility of a land use, appraisers should investigate other applicable

codes and ordinances, such as building codes, historic district ordinances, and en-
vironmental regulations. Building codes can prevent land from being developed to
what would otherwise be its highest and best use by imposing burdensome restric-
tions that increase the cost of construction. For example, the additional cost of a water
retention pond with excess capacity that is required by a local ordinance could affect
the size of a proposed community shopping center. Less restrictive codes typically
result in lower development costs and thereby encourage development, while more
restrictive codes tend to increase development costs and discourage development.
In some areas, restrictive building codes are used to slow new construction and limit
Probability of a Zoning Change

In investigating the reasonable probability of a zoning change, appraisers consider zoning trends and the history
of rezoning requests in the market area as well as documents such as the community’s comprehensive plan (or
master plan). Appraisers can usually eliminate the following from consideration as potential highest and best uses:
• Uses that are not compatible with the existing land uses in the area, such as a gas station in the middle of
an exclusive single-unit residential subdivision
• Uses for which zoning changes have been requested but denied in the past, such as an industrial use in
an area where several industrial zoning changes have been turned down in the past two years
On the other hand, a zoning change from residential use to commercial use may be reasonable if other
properties in the market area have received a similar zoning change recently or if a community’s comprehen-
sive plan designates the property for a use other than its current use. For example, consider a site zoned for
single-unit residential use in a transitional neighborhood where the zoning on several similar sites has been
changed recently to commercial. Also, the city’s comprehensive plan designates the property as lying within
a future commercial corridor. Both of these factors may support an appraiser’s conclusion that there is a
reasonable probability of rezoning the subject site for commercial use.
Market evidence supporting the possibility of new zoning can include rezoning applications, zoning
hearings, actions by municipalities, and interviews with planning and zoning officials. Even if there is no
current market evidence of a zoning change, documented interviews with officials and discussions of zoning
practices and histories can be helpful in evaluating the possibility of a zoning change. These interviews, like
any other market evidence, may, however, not be “proof” of a likely change or the denial of a change in zoning
but rather only support the estimate of the probability of a change in zoning. Decisions on zoning ordinances
are made by elected officials, and the processes are often heavily contested, costly, and time-consuming. The
outcomes are not known for certain until official actions are taken.
The probability of a zoning change is never 100%, which presents appraisers with two challenges in high-
est and best use analysis:
• To determine if the economic demand for an alternative use of the property being appraised under a
potential zoning change is greater than the economic demand for the real estate under the current zoning
• To provide market support for that conclusion
To manage their risk, most developers contract to buy property “subject to” rezoning approval rather than “as
is.” Many pending sales never close because they are subject to rezoning that could not be obtained within
the developer’s desired time frame or could not be obtained at all.
If appropriate for the intended use of the appraisal, a current opinion of market value may be based on the
hypothetical condition that the property has already been rezoned as of the current date of value. (However,
as stated earlier, some clients will not accept appraisals subject to that sort of hypothetical condition, instead
requiring that the property be valued “as is” with the existing zoning and, if appropriate, reflecting any additional
value due to the likelihood of a zoning change.) If the date of value is prospective, the opinion of value could
be based on the extraordinary assumption that the rezoning will have occurred by the prospective date of value.
A current opinion of market value that reflects the existing zoning but also reflects any premium that market
participants would pay because of the likelihood of a future zoning change would be the “as is” value. This value
would not be based on a hypothetical condition or extraordinary assumption relating to the zoning status.

growth. Historic ordinances and overlay districts may be so restrictive that they can
significantly restrict new development.
Concerns over the long-range effects of certain land uses sometimes result in
increased environmental regulation and stricter development controls. Appraisers
should be familiar with environmental regulations pertaining to clean air, clean wa-
ter, and wetlands, and they should be sensitive to the public’s reaction to proposed
development projects. When resistance from local residents and the general public
(sometimes called NIMBYism, for “not in my backyard”) occurs, it can pressure
elected officials to stop or limit certain real estate developments or change the density
or character of a specific plan.
Marketability analysis helps appraisers compare the maximum development
potential of a site that is legally permissible with market norms. For example, le-
gal restrictions and the size of a specific site may indicate a maximum of 100,000
square feet of building area for that site, but if buildings on sites with similar legal
and physical characteristics are being developed with buildings of 60,000 to 80,000
square feet, the difference may need to be accounted for in the analysis of the maxi-
mum productivity of the site as though vacant and reconciled in the analysis of the
highest and best use of the property as improved. When the market norms are more
restrictive than the legal restrictions, the market norms prevail in market analysis and
highest and best use analysis. For example, a local ordinance may require 4.5 parking
spaces per 1,000 square feet of office space, but the developers in the market may all
use 6.0 spaces per 1,000 square feet as a minimum.
Market norms can also influence a site’s potential for division as a legally permis-
sible option, i.e., the site could be used as is or subdivided. For example, the analysis
of the highest and best use of a 20-acre industrial site might start with an investiga-
tion of any legal restrictions on development of the entirety or on division and devel-
opment of smaller parcels.
As with zoning ordinances, if there are land use limitations inherent in any ap-
plicable codes, ordinances, and regulations, an appraiser should investigate whether
there is a reasonable probability of a change relative to the subject property along
with economic demand for change and any timing and cost considerations related to
a potential change.
Physically Possible Uses of Land as Though Vacant

A parcel of vacant land (or an improved site analyzed as though vacant) is the blank
canvas on which a real estate developer paints any number of pictures. The physical
possibilities of the vacant land are quickly constrained by factors such as site size,
shape, frontage, availability of utilities and other support services, topography, soil
composition, and other site conditions and environmental and locational factors. As
a simple example, an irregularly shaped parcel can cost more to develop and, after
development, may have less utility than a regularly shaped parcel of the same size.
In addition, if the irregular shape affects ease of access, certain land uses might not be
probable or even physically possible. For some developers of commercial real estate,
ease of access (e.g., number and placement of curb cuts) is the most important site
factor, but others may consider visibility to be paramount. It is also possible to have
too much traffic in front of a commercial site because that may cause too many cars
backing up at an automatic signal, which prevents crossover traffic from accessing

the site. For developers of industrial property, the access of the site for large trucks
may be the most significant physical attribute.
The information that appraisers use to analyze the physical possibility of a land
use is often collected in the property productivity analysis step of the market analy-
sis process, which also covers the legal and locational characteristics that connect the
property with sources of economic demand and set it apart from its competition. These
interconnected forces shape the use potential of the property. For a parcel of land ana-
lyzed as though vacant, the uses that are both legally permissible and physically pos-
sible make up the pool of alternative uses that can be analyzed for financial feasibility.
The location of real estate determines the type of land uses with the greatest
economic demand in an area. For example, a housing development for seniors might
be a permissible use for a specific site but, if most residents of the market area that
such a facility would serve are under 40 years old, this use is most likely not reason-
ably probable and would not be analyzed further for financial feasibility. Because the
attributes of a location changes over time, those dynamic features, such as land use
growth patterns and the direction and rate of this growth, also need to be addressed.
Location analysis addresses these major questions regarding the use potential and
competitive position of the property:
• Where does the subject property fit in the overall growth pattern?
• Where does the market for the subject property come from (i.e., linkages to demand)?
• How does the location of the subject property compare to the competition at the
present time and in the future, and what are the future implications for the mar-
ketability of the subject property?
Distinguishing the Physical Use of Real Estate from the Motivations of Users
The concept of highest and best use relates to what is done physically with real estate, and use of physical
land should not be confused with the motivations of owners or users. For example, conservation and pres-
ervation are not uses of land. Rather, they are the motivations of individuals or groups for acquiring certain
properties. The physical uses in these cases could generally be characterized as “leave the land vacant” or
“do not change the historic improvements.” A parcel of land encumbered by a conservation easement would
have legal limits on use, leaving “continue the existing use unchanged” or “development to some limited
degree as agreed upon by contract” as the only legally permissible use of the land.
Similarly, “assemblage with an adjacent parcel” is not a meaningful description of a property’s highest and
best use. While the process of assembling a site with other sites might make the most sense financially for
the entity who would benefit from the combination of multiple parcels, assemblage is a motivation for acquir-
ing a property, not a use of the real estate. In other words, an entity might be motivated to purchase a site so
that it can be assembled with surrounding parcels to create one large parcel, for which the highest and best
use might be, for example, development of a multistory residential condominium building. If the property be-
ing appraised is a single site, not a site whose use depends on assemblage with other sites, the highest and
best use of the site alone is usually analyzed as it currently exists by itself. If the property being appraised
consists of multiple sites as though sold in one transaction, the highest and best use analysis considers
them as one large site.
Land that is held primarily for future sale, with or without an interim use, may be regarded as a speculative
investment. (The concept of an interim use is discussed in Chapter 18.) In general usage, speculation may
carry a negative implication of high risk or uncertainty, but in the language of real estate appraisal specula-
tion refers to the acquisition of property motivated by the expectations of realizing a profit from a rise in price.
That is, the term speculation describes a motivation rather than a use.

Financial Analysis of Alternative Uses of Land as Though Vacant
As mentioned earlier, appraisers eliminate uses that are not legally permissible and
physically possible. As shown in more detail in Chapter 18, the financial analysis of
the remaining alternatives builds on the analysis of physical, legal, and locational
characteristics of a property, providing the estimates of economic demand and timing
that support the highest and best use conclusion.
In the analysis of financial feasibility, the alternative uses that have a positive
present residual land value for current development can proceed to the next step of
highest and best use analysis. Timing of use is a critical consideration. Some alterna-
tive uses might not currently have a positive land residual value but could still have
a land residual value in the future that is high enough to support an investor’s deci-
sion to hold the land for that future use. For example, consider a plot of land with
a current residual land value for apartment use of $6 per square foot. Currently, the
area lacks economic demand to support development of a retail property at that loca-
tion, but, if the land were held vacant for seven years for a future retail use, the land
value in seven years would be $20 per square foot, according to marketability analy-
sis conducted for the property. At a discount rate of 10% considering the forecast risk
and holding costs among other factors, the present value of the land as if held for
future retail use is $10.26, i.e., higher than the value of immediate development for
apartment use. The possible future use for retail development might have been over-
looked because of the lack of current demand for retail use, illustrating the impor-
tance of timing concerns in the development of highest and best use conclusions.
Maximum Productivity of Land as Though Vacant

Of the financially feasible uses of the land as though vacant, the highest and best use
is the use that produces the highest residual land value. The comparison of the values
of the financially feasible uses is usually straightforward.
To determine the highest and best use of land as though vacant, for each alter-
native use being tested, the cost to develop the requisite improvements is deducted
from the value of the property as if complete to calculate the residual land value. The
use that produces the highest land value on the effective date of the appraisal is the
highest and best use.
As an alternative, rates of return that reflect the associated risks of alternative
uses are often used to capitalize the residual income to the land from those uses into
their respective values. The rates are developed from previous research (i.e., mar-
ket and marketability analysis) and reflect the rates of return that are applied to the
range of alternative uses being considered in the market.
As another alternative, land sales can be used to test which alternative is maximally
productive when the comparable plots of land have the same or similar highest and
best use conclusions as the subject property. For example, suppose a site is currently in
demand for apartment use, and demand for retail space is estimated to arise five years
in the future with projected population and income growth in the area. The highest and
best use of the site can be tested by applying comparable sales data. Apartment land is
currently selling for $3.50 per square foot, and retail land that is ready for development is
forecast to sell for $7.50 per square foot in five years. If the retail land is held for five years
at a discount rate of 20%, the present value of the retail land is $3.01 per square foot,
which suggests that the highest and best use today is to develop apartments on the site.

Conclusion of Highest and Best Use of Land as Though Vacant
If an appraiser concludes that a building improvement is appropriate for the highest
and best use of a parcel of vacant land, the appraiser then determines and describes
the type and characteristics of the ideal improvement to be constructed. The use that
is considered the ideal improvement should meet the following criteria:
• It is supported by market and marketability analysis and the financial analysis of
alternative uses.
• It takes maximum advantage of the potential market demand for the site’s high-
est and best use.
• It conforms to current market standards and the character of the market area.
If a new improvement is considered capable of supporting the highest and best use
of the land as though vacant, it presumably will have no physical deterioration or
functional obsolescence. The ideal improvement identified in highest and best use
analysis helps appraisers estimate the effect of certain forms of depreciation in the
application of the cost approach because any differences represent inconsistencies
with market demands.
An appraiser’s conclusion of the ideal improvement should be as specific as the
market suggests through market analysis, e.g., to the level of the number of stories or
number of units built. The first step—property productivity analysis—of the six-step
process of market and marketability analysis determines the market segment that
the subject property could serve based on its features. The market might recognize
the use of the ideal improvement of a particular site as “community retail” or as
“neighborhood shopping center.” The specificity of the ideal improvement can test
the reasonableness of the highest and best use conclusion and affects the comparable
properties that might be analyzed in the application of the approaches to value.
Alternative Uses of the Real Estate as Improved

The theoretical focus of highest and best use analysis is on the potential uses of the
land as though vacant. In practice, however, the contributory value of the existing
improvements and any possible alteration of those improvements are just as impor-
tant as the land as if vacant in determining highest and best use and, by extension, in
developing an opinion of the market value of the property.
The concept of highest and best use of real estate as improved pertains to the use
that should be made of an improved property in light of the existing improvements
and the ideal improvement described at the conclusion of the analysis of highest and
best use as though vacant. In market value appraisals of improved property, apprais-
ers consider a number of alternative uses of the existing improvements:
• Retain the existing improvements and continue the current use as the highest
and best use.
• Convert, renovate, or alter the existing improvements to enhance the current use
or change the use of the property to a more productive use.
• Retain the existing improvements and continue the current use as an interim use.
• Demolish the existing improvements and redevelop the site.
In the case of continuing the current use as an interim use, the ongoing use of the
existing improvements would be an interim use that helps defray the cost of carrying

the property and demolition costs until all approvals have been obtained and actual
construction on a new use should begin.
All four criteria of highest and best use are relevant to the analysis of the property
as improved and any alternative uses considered. It is generally self-evident that the
current use of a property as improved is physically possible. That is, the existence of
the improvements proves that they can be built on that site. Likewise, the legal per-
missibility of the current use is often nearly as obvious and easy to confirm. But an ap-
praiser needs to test whether the existing improvements contribute value, rather than
simply assume that the current use is the highest and best use because the improve-
ments are already in place. In fact, the most persuasive analysis of the highest and best
use of the property as improved often first tests whether the existing improvements
should be demolished and the site redeveloped to the highest and best use as though
vacant, instead of starting from the assumption that the current use will continue.
Demolition of the improvements can be considered the most extreme form of
modification to the current use of the property as improved. If the value of the prop-
erty as improved is greater than the value of the site as though vacant less demoli-
tion costs, then the existing improvements contribute value to the property’s highest
and best use and should not be demolished at that time. When the improvements
no longer contribute positively to value net of demolition costs, then demolition and
redevelopment of the ideal improvement would be economically supportable. Many
buildings are torn down and their sites left vacant or left as improved for a variety of
reasons, e.g., property taxes, liabilities, or avoidance of vandalism and criticism that
the unused improvements are an “eyesore.” In these cases, the land is worth more as
vacant than as improved. (Interim uses will be discussed more fully in Chapter 18.)
If demolition is ruled out, then changes to the existing improvements—which may
include a change of use—should be tested. The recognized forms of modification are
• Conversion of the property to an alternative use
• Renovation of the improvements
• Alteration of the property
For any of these options to be financially feasible, the change must add at least as
much value to the property as it costs. In other words, the value after conversion,
renovation, or alteration less the costs of the modification (including entrepreneurial
incentive) must be greater than or equal to the value of the property as is. The costs
involved in any form of modification must include an appropriate estimate of entre-
preneurial incentive.
Testing the feasibility of modification is a straightforward comparison of the
contributory value of the change with the cost of making the change. However, any
modification of the existing improvements must still meet all four tests of highest and
best use for the modification to be considered the highest and best use. The study of
property productivity in the market analysis process is likely to show what changes
to the existing improvements are physically possible and legally permissible.
If all the alternative uses are eliminated and the current use remains financially
feasible without modification of the improvements or redevelopment of the site and
retains the highest value of the alternative uses, then the current use is the highest
and best use of the property as improved. Deferred maintenance of the improvements
may need to be addressed in the analysis of the financial feasibility of the current use.

Repairs may need to be made to the existing improvements for the current use to
achieve the best competitive position in the marketplace. The costs of curing physi-
cal deterioration or functional obsolescence, redesigning a building, or converting the
existing improvements into an alternative use (including a provision for entrepreneur-
ial incentive) should be analyzed in light of the value created in the market. The effect
on value of implementing any changes is more important than simply how much the
changes will cost. If the changes will not be economically feasible, the expenditures
would not be made—a point that an appraiser should incorporate into the highest and
best use analysis.
Consistent Use
The principle of consistent use holds that land cannot be valued based on one use while improvements are
valued based on another use. A site with existing improvements is valued as though vacant and available
for its highest and best use. Existing improvements that do not conform with the ideal improvement may
contribute some value or no value or even reduces value if the costs to remove the improvements are sub-
stantial. In the application of the cost approach, an adjustment for functional obsolescence may be needed
for an improvement that is not consistent with the highest and best use as though vacant. In other words, if
the improvements are not the highest and best use, any reduction or increase in value they create would be
attributed to the improvements, not the land.
Consider a single-unit residence on a valuable site rezoned for commercial use. This house, if zoned for
residential only, would be worth $450,000 and the land value with residential zoning would be $75,000. But the
site is zoned for retail use, and the land value is $500,000 with the current zoning. It is incorrect to add the land
value of $500,000 for use as a commercial site to the value of the building as a residence ($375,000) because
the residence is in the way of commercial development and would be demolished by a commercial developer.
Even though a property was developed with one use in mind, alternative uses are almost always physically
possible, just not always financially feasible or maximally productive. In the analysis of the highest and best
use of a property as improved, an appraiser considers the alternative uses by applying the same tests applied
in the analysis of the highest and best use of the land as though vacant. The future economic performance of
the existing improvements is the core concern in analyzing the alternative uses of the property as improved.

The Application of Highest 18
and Best Use Analysis
Traditionally, highest and best use analysis has been described in terms of four
“tests.” And those tests are theoretically applied to the subject property considered
from two perspectives: (a) the land as though vacant and (b) the property as im-
proved. In practice, however, the process of highest and best use analysis is more
effectively organized into eight steps that echo and amplify the process of market
and marketability analysis. Figure 18.1 lays out the eight steps in highest and best use
analysis as its own sequential process and illustrates how those steps map onto the
four fundamental criteria for the analysis of highest and best use.
The essential components of highest and best use analysis are
1 . A specific property’s physical, legal, and locational attributes that determine use
2. The economic demand for the potential alternative uses of that property
3. Estimates of the financial rewards for each alternative use
Those first two components are generated through market and marketability
analysis. The conclusion of that process provides the basis for the financial analysis
of alternative uses—the third component. That screening process then leads to
reconciliation and the final conclusion of highest and best use—i.e., the maximally
productive use.
At its core, highest and best use analysis is an examination of alternative uses of a
property, each use having its own characteristics related to the value-influencing fac-
tors of utility, demand, effective purchasing power, and scarcity. The goal of highest
and best use analysis is to determine which use produces the highest present value of
the future benefits. To accomplish that, the eight steps in highest and best use analy-
sis are used as a screening process, and alternatives are run through this screening
process until the highest and best use is determined.
Each alternative use of the property should be studied in sufficient detail to allow
an appraiser to make a logical, supportable decision about the alternatives in terms
of use, timing (of the demand for each use), and identification of market participants.
The same criteria for levels of study in market and marketability analysis apply to the
Figure 18.1 Eight Steps of the Highest and Best Use Analysis Process
Analyze property productivity attributes (site, • Physical possibility

Step 1. Property productivity
legal, and location) to eliminate uses and • Legal permissibility
analysis
determine most probable uses
Step 2. Delineate the market
Step 3. Demand analysis Perform market studies to determine the
Data required for
economic demand and timing for probable
Step 4. Supply analysis analysis of financial
alternative uses
Step 5. Residual demand analysis feasibility
Step 6. Subject capture analysis Perform marketability analysis
Complete a financial analysis of alternative
Step 7. Financial analysis of
land uses to determine which use has the Financial feasibility
alternative uses
highest residual land value
Perform highest and best use reconciliation
and draw conclusions:
• Use
Step 8. Highest and best use • Timing Maximum productivity
conclusions • Market participants
- Users of space
- Most probable buyer type
eight-step process of highest and best use analysis. If the property is a small, simple
property in a stable market and it is obvious that there is current demand, then the
highest and best use analysis would usually be simple (i.e., analogous to a Level A
market analysis). For example, for a single-family house in good condition in a stable
market with a consistent sales history in a neighborhood with a good long-term out-
look, the eight steps of the highest and best use analysis process can usually be com-
pleted in a short time, with inspection of the subject property and neighborhood and
review of the zoning and MLS records of sales trends. At the other end of the scale, if
a property is large, complex, or in a volatile market and if the timing of demand is an
issue, then the application of the eight-step process might be detailed and extensive.
(i.e., like a Level C market analysis) with quantifiable support for each step.
Alternative Use Scoping

The level of study applied to alternative uses may not always be the same for the
land as though vacant and for the property as improved. If the market value of the
land is less than the market value of the property as improved, then a significant
factor in the market value of the subject property is the future economic life of the im-
provements. In that case, more focus of the highest and best use analysis would be on
the property as improved. This might mean that the level of study for the land might
be a Level A market analysis, while the highest and best use analysis for the property
as improved might involve a Level C market analysis.
The testing of alternative uses starts with the possibility of demolishing the exist-
ing improvements and then, if the existing improvements should be retained, con-
tinues with an examination of the possibilities of conversion, renovation, or altera-
tion of the improvements. In the first case, the value of the land as thought vacant is
compared with the value of the property as improved less the cost of demolition. In

the case of possible conversion, renovation, or alteration, the cost and timing of those
options are compared to the potential increase in value.
Step 1. Property Productivity Analysis

The first step of the application of highest and best use analysis determines what
market segment the property features are designed to serve. Appraisers usually limit
the number of potential property uses to a few choices through the initial analysis
of the market and of the subject property’s site, improvements, land use regulations,
and location—i.e., property productivity analysis.
Often a ranking analysis of the features of the subject property places the proper-
ty in a competitive position in relation to the market standard for a particular use. As
an example, the location of an office property being appraised may be ranked against
competitive nodes for its quality of
• Linkages
• Ease of access
• Reputation
• Visibility
• Availability of support facilities
The success of a retail center depends on different characteristics of the subject prop-
erty such as
• Location
• Tenant mix
• Amenities
• The number of households in the trade area
• Proximity to new retail development
• Proximity to the path of growth (e.g., new or projected residential development)
• Household income
• Proximity to major roads
Also, the ranking of a retail center considers the characteristics of the retail node such as
• Traffic counts by each shopping center
• Complementary land uses
• The size and drawing power of the anchors
• Tenant mix and compatibility in the retail node
• The effective age and reputation of the centers in the retail node
Each of the factors relevant to a particular property type is ranked as part of the
analysis of location in the property productivity analysis.
Factors relevant to the property analysis of an apartment building include
• Proximity to existing development
• Public planning/development support for apartments
• Location in path of new residential growth
• Proximity to major roads (existing or approved ease of access and visibility)
The Application of Highest and Best Use Analysis 319

• The reputation or prestige of the area (e.g., social reputation)
• Proximity and ease of access to shopping centers (convenience and shopper goods)
• Proximity and ease of access to employment centers
• Aesthetics of natural features in the area
• Proximity to entertainment and cultural areas (theaters, parks, golf, restaurants)
• Proximity and reputation of schools in the area
The property productivity analysis delineates the alternative uses of the property
that are analyzed in the next steps of highest and best use analysis. The demand for
each probable use is studied through market analysis to determine the market de-
mand and market conditions for each alternative use. The marketability analysis com-
ponent of the process determines the timing of the use of the subject property such as
the future start date for construction or a forecast of occupancy.
Steps 2 to 6. Market Analysis and Marketability Analysis

The central portion of highest and best use analysis is an iterative process that
provides support for the forecast of economic demand for the subject property. The
processes of market analysis and marketability analysis are repeated for all the rea-
sonably probable alternative uses being considered. Specifically, the second through
sixth steps are applied to each alternative use, as shown in Figure 18.2. In Step 1,
highest and best use analysis examines the subject property’s competitive position
based on the property characteristics and legal and location factors. The iterative pro-
cess of Steps 2-6 extends the analysis to address the amount of supply and demand
for the land uses that are most probable at the site of the subject property.
In market analysis, the task of delineating the market for a particular land use
involves identifying the typical users of a property that is put to a particular use. The
various alternative uses often have different market areas relevant to the particular
use, which the second step of highest and best use analysis addresses.
Demand analysis measures the need for a specific land use. In the context of
highest and best use analysis, the study of demand for an alternative use answers the
question of whether a specific alternative use is needed. The supply analysis step of
highest and best use analysis determines what the competition for each alternative
use is and how much competition exists.
The fifth step of highest and best use analysis is critical in determining the timing
of new construction for each alternative use. That is, the comparison of supply and
demand leads to an estimate of when the market would support new construction of
a particular use or the future outlook of occupancy of existing properties.
The marketability analysis conclusion for each alternative use completes the iterative
process at the heart of highest and best use analysis. The subject capture analysis deter-
mines the competitive position of the property’s location and physical attributes, ulti-
mately providing support for an estimate of the timing of new construction on the subject
site or of the future occupancy outlook of existing improvements on the subject property
over the typical market cycles in the user market. This study of economic demand sets
the stage by providing data input for the next step—the financial testing of alternatives.
The subject capture potential that is estimated in highest and best use analysis
must consider competitive properties, whether they are vacant sites or improved

Figure 18.2 The Iterative Analysis of Alternative Uses
Problem Definition of Highest and Best Use Analysis

The reasonably probable use of property that results in the highest value. The four criteria that the highest and
best use must meet are legal permissibility, physical possibility, financial feasibility, and maximum productivity
Economic Overview and Alternative Use Scoping

Site, improvement, legal, and locational determinants of most probable uses
Aternative Use 1 Aternative Use 2 … Aternative Use n
Market Analysis and Market Analysis and Market Analysis and Market Analysis and
Marketability Analysis Marketability Analysis Marketability Analysis Marketability Analysis
Step 2. Delineate the Step 2. Delineate the Step 2. Delineate the Step 2. Delineate the
market market market market
Step 3. Demand Step 3. Demand Step 3. Demand Step 3. Demand
analysis analysis analysis analysis
Step 4. Supply Step 4. Supply Step 4. Supply Step 4. Supply
Step 5. Residual Step 5. Residual Step 5. Residual Step 5. Residual
demand demand demand demand
Step 6. Subject Step 6. Subject Step 6. Subject Step 6. Subject
capture capture capture capture
Financial Analysis of Financial Analysis of Financial Analysis of Financial Analysis of

Aternative Use 1 Aternative Use 2 Aternative Uses Aternative Use n
Highest and Best Use Conclusions

Specified in terms of
• Use
• Timing
• Market participants
- Users of space
- Most probable buyer type

properties. There may be significant demand for a use in the subject property’s mar-
ket area and the subject property may indeed be suited for this particular use, but a
number of other sites may be equally well suited or more appropriate.
Appraisers should also consider the competition among various uses for a
specific site. For example, competition for available sites along a commercial strip
development may be intense. Developers of community retail facilities, garden office
space, and fast food restaurants may bid against one another, and the prices they pay
for these sites will reflect the competition between buyers. However, market demand
is not infinite. Even though the subject property may be physically and locationally
suited for a particular use, better-located sites may satisfy the market demand for
that use completely before the subject property can realize its development potential.
Step 7. Financial Testing of Highest and Best Use Alternatives

The financial testing of each alternative use provides the framework for analyzing
which alternative use has the highest value. The desire for a particular use in a partic-
ular location is essential. Clues that supply and demand may not support a particular
use include vacancy throughout the market area or no new construction when land is
available. The results of market analysis can lead to the potential consideration of the
presence of obsolescence.
For income-producing properties, the income analysis should be supported with
market and marketability analysis. The financial analysis of alternatives will often
focus on which potential uses are likely to produce an income (or return) equal to or
greater than the amount needed to satisfy operating expenses, financial obligations,
and capital amortization of each investment. However, supply and demand are still
essential considerations even if cash flow is positive, i.e., the financial analysis of
alternative uses does not necessarily end with cash flow analysis.
Some economic uses of land, such as housing, may not be income-producing in
the sense of a commercial property, and economic feasibility is weighed by consider-
ing prices and price trends. If the uses are not income-producing, the financial analy-
sis will determine which uses are likely to create a value or result in a profit equal to
or greater than the amount needed to develop and market the property under those
uses—and of those uses, the use that produces the highest value.
The timing of alternative uses is a key consideration in highest and best use anal-
ysis because highest and best use is subject to change. In particular, the financial anal-
ysis of alternative uses is sensitive to the market acceptance of that use at the present
time or at a future time. As an example, consider a ten-year-old, single-unit residence
located next to a street that was just widened and where traffic increased 300% from
the previous year. After the road widening, the area was rezoned from residential use
to commercial use. The value of the improved residential property is $500,000, and
the land value as though vacant with commercial zoning is $475,000. The contribu-
tory value of this ten-year-old residential structure is $25,000. If land prices increase
slightly, the building will be removed. In the application of the cost approach to value,
the building would be considered almost worthless, although it is only ten years
old. The residential structure is the wrong improvement for this commercial site and
would pay the penalty in the form of obsolescence for misuse of the site.
Uses that are not currently financially feasible for new construction can be analyzed
to forecast when they would be financially feasible at some point in the future, i.e.,

when market rent rises above feasibility rent. The residual demand analysis that is part
of the market analysis process provides the information needed to help forecast when
a use will become financially feasible. Holding a property for future use may produce a
higher present value than current development of a different use on the property.
Alternative uses that are currently financially feasible and those that are forecast
to be financially feasible can be compared with discounted cash flow analysis, which is
discussed in detail in Chapter 27, or with other methods such as the analysis of the pres-
ent value of end-user sales to owner-developers, which is discussed later in this chapter.
The financial feasibility of a potential alternative use may not be the reason it is not
currently the highest and best use. Sometimes the problem is revealed earlier in the test-
ing process, e.g., property productivity analysis. A piece of land can be stripped of any
viable economic use as a stand-alone entity by legal and physical constraints such as
• An inability to obtain a building permit
• Restrictive covenants that preclude any economic use or structure
• The presence of easements
• An inability to comply with lot area, lot dimension, or setback requirements
• No legal means of access
• Lack of accessibility (isolated location or abutting an unopened road allowance)
• Unfavorable topographical features
• Unfavorable soil conditions, including environmental contamination
• An irregular configuration
• An inability to secure essential services (water supply and sewage disposal either
on site or off site)
• Development rights that were previously sold
Also, the immediate development of a financially feasible use may not be the current
highest and best use because of delays in the development process such as a protracted
permitting period. That sort of delay becomes part of the timing element of the highest
and best use conclusion.
The demand for a location may suggest that a parcel is a prime retail corner at
some point in time, but if the retail potential is some years in the future, another
use—for example, apartments—that can be developed immediately could make the
land more valuable today. For an existing property subject to a lease that is near expi-
ration, the demand for the continued use of the property or conversion to another use
may be a timing issue. Timing is a central issue in the analysis because the highest
and best use is the use with the highest present value.
Prices and price trends can be important indicators of economic performance.
Recent sales to owner-users could indicate that the economic performance of certain
uses of real estate has recently reached the level of financial feasibility, or it could
indicate that the market is becoming overdeveloped. If market conditions have
changed since the last sales occurred, economic performance in the current market
might be affected. Sales to speculative investors are more likely to indicate a market
in transition, in which case current or proposed uses are not likely to be financially
feasible. Other possible market indicators of economic performance include current
and historical vacancy rates, current and historical rental rates, recent construction
activity, and recent space absorption.

Financial Analysis of Alternative Uses
Many different techniques can be used to help guide the final highest and best use
conclusion of which alternative use produces the highest present value. All the tech-
niques commonly used by appraisers have certain factors in common.
First, the analysis should consider the amount and timing of all cash flows until
the property reaches its peak income performance. In most properties, the peak
performance is not typically sustained over the long term. Rather, economic perfor-
mance usually rises and falls with market cycles.
Second, the model used should take into account the appropriate risk attributed
to each of the cash flow forecasts for each use considered. In general, more support
for the cash flow forecast from market analysis means less risk than a forecasted
cash flow based only on general data. If different alternatives have different forecast
expectations, then (a) the discount rate could be adjusted for this risk, (b) the forecast
could be adjusted to match the alternative use’s forecast expectation, or (c) the differ-
ent risk could be explicitly addressed in the reconciliation of the highest and best use.
Finally, the analytical technique applied should be able to consistently select the
alternative use that will produce the highest financial reward, assuming that all alter-
natives have the same probability for realizing the forecasted cash flows.
The five techniques used most commonly in financial analysis are
• Land residual analysis
• Discounted cash flow analysis
• Feasibility rent analysis
• Analysis of profitability index
• Analysis of the present value of end-user sales to owner-developers
Multiple methods may be needed to analyze alternatives depending on the reliability
of the techniques used.
Land Residual Analysis

For any alternative use of vacant land, the cost of construction (including an estimate
of entrepreneurial coordination), the forecasted timing for the use, and the expected
value of the specific property use should be known. The difference between the pres-
ent value of the benefits of developing the property and the cost to develop it is the
land residual, which is a primary indicator of financial feasibility. The land residual
analysis provides the land value required for new construction to be economically
justified. If the land residual is positive, the use is considered financially feasible, as-
suming that the land can be acquired for the residual amount or less.
The land residual model should be repeated for each alternative being consid-
ered. The development cost of each alternatives use will probably be different and
should be reflected in the financial model. The different timing expectations (e.g.,
start date, construction time, and lease-up time) should also be reflected in the model,
which is usually a discounted cash flow analysis.
As an example, suppose that a 25,000-sq.-ft. office building is deemed a reason-
ably probable use of the site as though vacant. If construction costs (including leasing
commissions and rent loss during lease-up) for office buildings of a similar class in
the market area are $125 per square foot and entrepreneurial incentive in the market
has consistently equaled 10% of building costs, the total cost to construct the im-

provements would be $3,437,500. Similar improved properties would be expected
to sell for $150 per square foot in the current market, so the expected value of the
completed and leased-up property would be $3,750,000. The residual site value of the
leased-up building would then be $312,500:
Cost to Construct Improvements 25,000 sq. ft. × $125 per sq. ft. × 1.1 $3,437,500
Sale Price of Property 25,000 sq. ft. × $150 per sq. ft. $3,750,000
Residual Site Value $3,750,000 - $3,437,500 $312,500
The office building would be considered financially feasible if the contributory value of
the land was competitive in the market.
Discounted Cash Flow (DCF) Analysis

When improvements need to be considered (such as new construction, remodel-
ing existing buildings, or continued operation of existing buildings) in highest and
best use analysis, a discounted cash flow analysis is usually required to estimate the
contributory value of the real estate. DCF analysis is also an appropriate tool when
rezoning costs or anticipated changes in market conditions have to be accounted for
in the analysis of the present value of alternate uses. The application of discounted
cash flow analysis is illustrated in detail in Chapter 27.
Feasibility Rent Analysis

Feasibility rent is the rent necessary to justify new construction. In a balanced mar-
ket, feasibility rents are equal to market rents. The concept of feasibility rent helps
appraisers determine the timing of development, i.e., when current rent levels in the
market are expected to rise to the feasibility rent level.1
A carefully developed comparison of market rent with feasibility rent also
serves as a quantitative indicator of financial feasibility. Market rent can be seen as
an estimate of market demand (and affordability) for the current use, and feasibility
rent is the rent necessary to justify new construction. Market rent is often estimated
in the property productivity step of market analysis to compare locations. Feasibility
rent is calculated by reversing the cash flow format used in the income capitaliza-
tion approach—starting with net operating income, adding expenses, and adding the
vacancy allowance to arrive at gross income.
As an example, suppose that the ideal improvement for a site is a small industrial fa-
cility that would cost $1,750,000 to construct, including entrepreneurial incentive and all
other indirect costs based on an estimate of the sale prices of comparable sites, the cost
of preparing the site, and the estimated cost of building the 50,000-sq.-ft. facility. Market
research supports an overall capitalization rate of 6.75%.2 The required net operating
income could be calculated using this information, i.e., $1,750,000 × 6.75% = $118,125.
Feasibility rent is then calculated by (1) adding operating expenses, (2) adjusting for va-
cancy and collection loss, and (3) converting the potential gross income to the standard
unit of comparison, in this case, feasibility rent per square foot:
1. In addition to its use in the financial analysis of alternative uses, the analysis of feasibility rent is a powerful tool in the estimation of depreciation
because the capitalized difference between feasibility rent and market rent represents total depreciation (if market rent is less than feasibility rent).
2. If the sales market is at a critical inflection point in the market cycle, a more sustainable overall rate adjusted for the sales market cycle or a rate
based on the fundamental user market for alternative investments should be used.

Net Operating Income ($1,750,000 × 6.75%) $118,125
Operating Expenses ($2 per square foot × 50,000 square feet) + $100,000
Effective Gross Income $218,125
Plus Stabilized Vacancy and Collection Loss (5%) ÷ (1 - 5%)
Potential Gross Income $229,605
Feasibility Rent per Square Foot ($229,605/50,000) $4.59
The calculated feasibility rent can be compared directly to market rent to determine
financial feasibility. In this case, if a marketability study indicated that industrial
facilities of the same type would be expected to have a market rent of $5 per square
foot, the proposed development would be financially feasible. If the market rent
were lower than the feasibility rent of $4.59, the proposed development would not be
financially feasible.
Analysis of Profitability Index

Analysis of the profitability index, which is similar in concept to the net present
value of an investment, directly compares the value contribution of some action such
as developing a proposed property on a particular site with the cost of that action.
Analysis of the profitability index of a land use is most useful in the analysis of the
financial feasibility of conversion, renovation, or alteration of an improved property,
although it can be used to measure the feasibility of establishing alternative uses on
vacant land. (Further explanation and examples of the use of the profitability index
are covered in Chapter 27.)
Analysis of the Present Value of End-User Sales

The defining characteristic of sales of property made to “end users” is that the buyer
will make the property available to the user of the space for immediate occupancy.
The values of alternative uses can be discounted to compare differences in market tim-
ing and ultimately to determine which alternative provides the highest present value.
The discount rate can be adjusted for holding costs and any appreciation expected
in sale prices, or the actual cost and appreciation can be accounted for in a discounted
cash flow analysis. Note that any appreciation in the prices of end-user sales is not
necessarily an inflation adjustment in a fundamental analysis. That is, the price appre-
ciation could include some expected change in future buying power such as dispos-
able income after inflation. Some appraisers use an inflation-adjusted discount rate.
Consider a two-acre commercial site on a major thoroughfare. Four uses were
forecasted through marketability analysis to be in demand for the site:
• branch bank
• pharmacy
• service station
• fast food restaurant
However, the timing of the demand for each use varied, as illustrated in Table 18.1.
All of the forecasts of timing were judged to have equivalent reliability, and a
constant discount rate of 20% was considered reasonable. The land value is estimated
to be stable for the next few years in the market of end users. Ultimately, the alterna-
tive that produces the highest present value is use of the site for the development of a
fast food restaurant, as indicated in Table 18.2.

Table 18.1 Timing of Demand
User Price Date of Most Recent Estimated Mid-Range Forecast
Use per Sq. Ft. Sale to End User of Timing for Demand for End User
Branch bank $23 2 years ago 3 years from now
Fast food restaurant $19 3 years ago 1 year from now
Pharmacy $25 current 4 years from now
Convenience store $16 1 year ago 1 year from now
Table 18.2 Discounted Value

Fast Food Convenience
Bank Restaurant Pharmacy Store
User price per square foot $23 $19 $25 $16
Future timing for use (years) 3 1 4 1
PV @ 20% $13.31 $15.83 $12.06 $13.33
Step 8. Reconciliation and Conclusions

In the reconciliation of highest and best use analysis, the various inputs in the data
analyses from earlier steps in the process are reviewed. The resulting financial analy-
ses by various methods are also analyzed and the methods considered most reliable
form the basis of the highest and best use conclusion. In addition, the results of the
analysis of inferred demand are reconciled with the calculated financial analyses.
The resulting reconciliation conclusions of highest and best use for both the land
as though vacant and the property as improved (or as if improved as proposed)
should be presented in terms of
• Use
• Timing
• Market participants
Traditionally, appraisers have emphasized the physical use in the conclusion of high-
est and best use, but all three considerations are important in identifying the highest
and best use fully.
The development of those conclusions in the market analysis process is integral
to highest and best use analysis, which in turn is integral to the valuation of the prop-
erty. The most probable buyer is a critical conclusion used in choosing comparable
sales in the sales comparison approach. The probable space user is critical in choos-
ing comparable leases in the income capitalization approach.
In any report of a highest and best use conclusion, an appraiser should provide
market evidence that leads the reader of the appraisal report to an understanding of
the use and the timing (or future occupancy) for the use. The property type, size, and
market conditions provide an indication of how detailed the fundamental data needed
will be, which will dictate to a large extent how specific the conclusion of the highest
and best use of a property should be. However, all three parts of the highest and best
use conclusion are needed at some level to reliably apply the approaches to value. For
example, the selection of comparable sales is based on properties with a similar high-

est and best use as the subject property, so that requires some basis to determine if the
comparable properties have a similar use, timing for use, and market participants as the
subject property.
Reporting Highest and Best Use Conclusions

In an appraisal report that includes an opinion of market value, a discussion of, or ref-
erence to, a separate marketability study (of either inferred demand or fundamental
demand) may need to precede the discussion of the highest and best use determina-
tion to provide context for the highest and best use conclusions. A marketability study
is particularly important in the appraisal of vacant land, of new or proposed construc-
tion, and in transitional or complex markets.
In addition, highest and best use analysis often incorporates techniques and data
from the application of all three approaches to value. In many appraisal assignments,
the financial analysis of alternatives and the test of maximum productivity require
information that is obtained from the application and development of the approaches
to value. Therefore, even though the discussion of highest and best use traditionally
precedes the approaches to value in an appraisal report, the conclusion of highest
and best use often can be finalized only after a preliminary analysis of alternative
land uses has been performed. The conclusions of use, timing, and market partici-
pants reported in the highest and best use section of a report should be consistent
with conclusions and applications in the other parts of the report.
Special Situations in Highest and Best Use Analysis

In the identification and testing of highest and best use, special considerations are
required to address the following situations:
• Excess land and surplus land
• Proposed construction
• Legally nonconforming uses
• Illegal uses
• A use that is not currently the highest and best use
• Mixed uses
• Special-purpose properties
Excess Land and Surplus Land

The related but distinct concepts of surplus land and excess land were introduced in
Chapter 12. The proper treatment of unused land on an improved site can be an im-
portant consideration in highest and best use analysis. Both excess land and surplus
land have a common characteristic in that they are not needed to serve or support the
existing improvement. However, only excess land has the potential to be separated
from the rest of the improved property and to be used at its own highest and best use.
Also, the highest and best use of the excess land may or may not be the same as the
highest and best use of the main parcel. In contrast, surplus land cannot be separated
from the improved property and sold with an independent highest and best use.
A site with excess land may be able to support two separate highest and best
uses: (1) the highest and best use of the land used to support the existing improve-

ments and (2) the highest and best use of the excess land. Surplus land, meanwhile,
is currently unused land that might at best be used for the expansion of the existing
improvements, i.e., a modification of the current use, if legally permissible and finan-
cially feasible. Surplus land is sometimes used in improvement density calculations
for zoning requirements, which may be a factor in deciding if that area is needed to
support the existing improvements.
A variety of physical, legal, and other factors can affect whether unused land can
be classified as excess land. For example, a lease that covers all of the land of an un-
derimproved property can postpone or delay development or separate use of excess
land until the lease expires.
When the appraised property includes excess land, the excess portion and the
improved portion are valued separately, each based on its own highest and best use.
If an appraisal assignment includes valuing an improved parcel and an accompany-
ing parcel of excess land together as though the two were sold in one transaction, the
appraiser must consider the cost of splitting the entire parcel (including entrepre-
neurial incentive), which may be so significant that the separation of the excess land
may not be economically feasible. The sum of the values of the improved parcel and
the excess land may equal the value of the whole, or an adjustment may be needed to
that sum to reflect a combined sale. If two separate value conclusions are provided—
one for the improved parcel and one for the excess parcel—but the parcels are not
legally separated, the values are based on the hypothetical condition that the parcels
are legally separated.
Proposed Construction
Analysis of the highest and best use of the land as though vacant can often involve an
analysis of proposed construction. For example, consider an assignment in which the
land is vacant at the time the appraisal is prepared, and the assignment calls for the
appraiser to develop an opinion of market value that is either
• A current value, subject to the hypothetical condition that the proposed improve-
ments are built as of the current date, or
• A prospective value, subject to the special or extraordinary assumption that the
proposed improvements will be built as of the future date of value
In either case, an appraiser analyzes the highest and best use of the property as if
improved as proposed. These sorts of extraordinary assumptions and hypothetical con-
ditions are based on a conclusion developed from the appraiser’s research and data,
i.e., that the improvements will be completed at a certain time in the future when the
market would accept that use.
The specific improvements that are proposed may or may not represent the highest
and best use of the real estate if improved as proposed. The highest and best use analy-
sis process is applied just as it is for any improved property to support an appraiser’s
conclusion as to which use is most desired in the market. Proposed construction may
involve all completely new construction or a modification of the existing improve-
ments, but in either case the eight-step process is applied to the proposed improve-
ments and reported with a clear presentation of an appraiser’s projection of the timing
of the proposed use. Even though the improvements are not yet constructed, they may
suffer value loss by obsolescence if they are not similar to the ideal improvement.

Legally Nonconforming Uses
A legally nonconforming use is a use that was lawfully established and maintained
but no longer conforms to the current land use regulations of the zone in which it is
located.3 Some legal nonconformities can be created by governmental action such as a
partial taking in an eminent domain proceeding. Consider a gas station property with
20,000 square feet of land, which is the minimum amount of land area required by
local zoning for gas station use. If the city acquired 1,000 square feet of the land for an
intersection improvement, the site would then contain 19,000 square feet and would
no longer conform to the zoning requirements for site size. Other legally nonconform-
ing use situations can be created when codes and ordinances are changed. For exam-
ple, suppose a one-unit residence on a 7,500-sq.-ft. site in the core residential district
of a community zoned R-1 requires at least 7,500 square feet of land area. If the city
adopts a new zoning ordinance in which the minimum site size for a lot zoned R-1 is
increased to 10,000 square feet, the existing property will no longer conform. In both
instances, the property uses are considered legally nonconforming uses because they
were caused by an action of a governmental body. Changes in building codes, which
happen regularly in cities, can also make a property legally nonconforming.
For properties with legally nonconforming uses or properties with improvements
that differ significantly from the ideal improvement, an appraiser should determine
whether the property can continue to operate as its current use and alternatively
whether applicable codes, ordinances, or private restrictions allow modification of
the improvements that would bring them into conformity. This may involve analyz-
ing the reasonable probability of a change in zoning as conducted in testing the high-
est and best use of the land as though vacant. Again, an appraiser should report any
evidence supporting a reasonable probability that a change could be made to bring
the improvements into conformity with a particular code, ordinance, or restriction.
Such evidence could include trends in the market area, historical changes to codes or
ordinances in the area, or a community’s master plan.
Some communities also differentiate between (1) legally nonconforming uses and
(2) properties that are legal land uses but do not conform to current development
norms. In the former case, the use is nonconforming. In the latter, the property is still
being used in accordance with the zoning even though the site (or the improvements)
may be too small or otherwise inconsistent with development norms. The ideal im-
provement will meet both the legal requirements and the market norms. Most zoning
ordinances have special sections that deal with nonconforming use situations, and
appraisers should be familiar with them.
Zoning changes may create underimproved or overimproved properties. A one-
unit residence located in an area that is subsequently zoned for commercial use may
be an underimproved property. In this case, if there is demand for commercial use,
then the residence may be removed so that the site can be improved to its highest
and best use. On the other hand, if there is adequate current demand but there is
demand forecast in the future, the residence will be considered an interim use until
conversion to commercial use is financially feasible. In this case, the conclusion of
highest and best use would be to leave the property devoted to its interim use until
3. The traditional term legally nonconforming use has many synonyms constructed with similar words, e.g., legal nonconforming use and legal but
nonconforming use. However, neither the words legal or legally are necessary modifiers. In plainest terms, a use that can continue is nonconform-
ing, and a use that cannot continue is illegal.

the forecast date when redevelopment is financially feasible. A legally nonconform-
ing property can be an overimprovement when zoning changes reduce the permitted
intensity of property use. For example, the site of an older apartment building with
eight units in a fully built-up neighborhood might be downzoned to a less intense
use. That is, if the vacant site were developed now, the new zoning restrictions would
only allow six units to be built. Nonconforming uses also commonly result from
changes in development standards that affect features such as landscaping, parking,
setbacks, and access.
Zoning ordinances usually permit a preexisting use to continue but may pro-
hibit expansion or major alterations of any structures that support the nonconform-
ing use. This is especially true in the case of flood hazard rules of the federal flood
insurance program. Some jurisdictions specify a time period for phasing out legally
nonconforming uses. In some jurisdictions, a nonconforming use that is discontinued
cannot be reestablished, whereas in other jurisdictions, a nonconforming use must be
eliminated if the property suffers major damage or if the property is abandoned for
a statutory period of time. In some instances, a nonconforming use can be rebuilt to
the same intensity of use that it had prior to its destruction, provided it has no more
impact on the market area (e.g., a detrimental effect on neighboring properties) than
it did before.
A zoning variance can create a legally nonconforming use. An area variance (less
commonly known as a use variance) may be allowed due to special circumstances
applicable to a specific property, when strict application of the provisions of a devel-
opment code deprives the property of privileges commonly held by other property
in the vicinity that is under the same zoning. When a variance is granted, the legally
nonconforming use usually can be rebuilt without taking any unusual steps, in con-
trast to an existing use that is legally nonconforming. Appraisers should be careful to
research if a variance is only for the current owner and the current use. If the variance
is issued to the current owner for that specific use and it expires when the property is
transferred to a new owner, the use allowed by the variance will not be permitted for
the new owner.
When valuing land with a legally nonconforming use, an appraiser should recog-
nize that the current use may be producing more income, and thus have more value,
than the property could produce with a conforming use. The legally nonconforming
use may also produce more income and have a higher value than comparable proper-
ties that conform to the zoning. Therefore, when an opinion of the value of a property
with a legally nonconforming use is developed in the sales comparison approach,
an appraiser should consider the demand for the higher intensity of use allowed for
the subject property and also consider the risks and limitations associated with the
nonconformity. If the improvements could not be replaced if destroyed (for example,
by fire or flood), there is the risk that the income produced by the property will cease,
and this risk must be reflected in the valuation to the degree that it is acknowledged
by market participants.
In the case of the eight-unit apartment building in an area downzoned to six-
unit developments, for example, the capitalization or discount rates in the income
capitalization approach may need to reflect any increased risk associated with the
nonconforming use, specifically the risk that the improvements could not be rebuilt
if destroyed. In the sales comparison approach, the subject property would be treated

as an eight-unit apartment, but to reflect this risk, adjustments would need to be
made to comparable properties unless they too are similarly legally nonconform-
ing uses. An appraiser will have to determine whether sales of properties with six
units are appropriate comparable transactions in applying the sales comparison and
income capitalization approaches or whether the sales should be of properties with
eight units. In the cost approach, any increment in value due to the legally noncon-
forming use is attributed to the improvements, not to the land, if the improvements
could not be rebuilt.4
A zoning ordinance does not control the economic demand for a property, but
rather the market does. For example, a property rezoned from residential use to
commercial use does not necessarily increase in value. There may still be demand for
residential improvements in the market area but not for commercial improvements at
this location. In this example, the zoning change would not increase the value of the
land. In addition, if high economic demand is found for the current use, then the cur-
rent, legally nonconforming use may be producing more income than the rezoned,
conforming use would.
In some cases, a legally nonconforming use designation may affect the value of
a property negatively. Appraisers must understand enough about the legal require-
ments affecting properties in the area to be able to identify when there are further
issues to consider. For example, in many municipalities a nonconforming use cannot
be rebuilt if it is completely or partially destroyed. Some lenders consider the restric-
tion on rebuilding a risk, and lending practices or parameters for conforming and
nonconforming properties may differ. As a result, some lenders require insurance
against loss due to the nonconforming use, thus reducing net income to the property
and therefore value.
It is often easy to recognize a legally nonconforming use that corresponds to the
highest and best of the property as improved. Sometimes, however, it is not clear
whether a legally nonconforming use is the highest and best use of the site as though
vacant. Answering that question usually requires careful analysis of (a) the selling
price or income produced by the legally nonconforming use and (b) the selling prices
or income levels that would be produced by alternative uses of the land if the prop-
erty were brought into conformity with existing regulations. In most cases when a
legally nonconforming use is allowed to continue for the remaining economic life of
the improvements, the market will probably not distinguish between a legal use and
a legally nonconforming use. But a legally nonconforming use can create a problem
in the application of the cost approach, where the value of the land and the value of
the improvements are summed to develop an indication of value of the property as
a whole. When the land is valued as though vacant, that estimate of value can be se-
verely diminished by the existence of zoning or land use regulations, but the market
for the improved property may view the property as if the improved use were legal,
i.e., without an impairment to the land value.
Illegal Uses
Sometimes a property being appraised includes improvements that were constructed
without permits. Often in these cases the client will instruct the appraiser to “just ig-
4. If legally nonconforming uses could be rebuilt, any incremental value due to those uses would be attributed to the land. This is because legally
permissible uses of the land as though vacant would include the legally nonconforming use in this case.

nore” the illegal portions, but this is inappropriate. If the appraiser does “ignore” the
illegal improvements, the appraisal is premised on the hypothetical condition that
the illegal improvements do not exist when in fact they do exist, and the hypothetical
condition must be clearly disclosed in the appraisal report.
To value a property with illegal improvements in its “as is” state, the appraisal
must reflect the cost to remedy the illegality—i.e., to either remove the illegal im-
provements or obtain legal permissibility. Obtaining legal permissibility might
include upgrading the improvements so they conform to building codes and the pay-
ment of fees or fines.
Use That Is Not Currently the Highest and Best Use

The timing of alternative uses is a consideration in the conclusion of highest and best
use because highest and best use is subject to change. In particular, the financial fea-
sibility of an alternative use can be sensitive to the market acceptance of that alterna-
tive use now or at a future time. When no alternative uses are currently financially
feasible, an appraiser should analyze when an alternative use will, if ever in the fore-
seeable future, become financially feasible and therefore become a candidate for the
maximally productive use. If the maximally productive use of a property is delayed
for legal or financial reasons, then the highest and best use of the property would
be to leave the property as is until that prospective use can be achieved, e.g., when
land value rises to the level that modification of the current use is legally permissible,
financially feasible, and maximally productive.
The current use that the property is put to until it is ready for a more valuable
use has traditionally been known as an interim use. When it is not financially fea-
sible on the date of value to put the property to a more valuable use, the appropri-
ate highest and best use to be analyzed includes both the future use and the interim
use. In other words, when developing a market value opinion for such a property,
an appraiser must take into account the anticipated change in use in the future. The
interim use may contribute to the value of the property up to the point at which it
becomes feasible to change the use.
Interim use improvements may or may not contribute much, if anything, to the
value of the land as though vacant. If they cannot produce gross revenues that exceed
reasonable operating expenses, the improvements do not contribute to property
value. Indeed, the value of the property as improved may be less than the value of
the land as though vacant when demolition costs and real estate taxes are consid-
ered. However, many outmoded improvements that clearly do not resemble the ideal
improvement do create an increment of value over the value of the land as though
vacant. Also, the interim use may have value to the property user to the extent that
the income generated by the improvements defrays the costs of carrying the property,
the cost of demolishing the improvements, or both.
Uses that are not currently financially feasible must be analyzed to forecast when
they would be financially feasible at some point in the future, such as when market
rent reaches feasibility rent (i.e., the rent level necessary to justify new construction).
The residual demand analysis that is part of the market analysis process provides
the information needed to forecast when a use will become financially feasible. (This
is another example of the importance of market analysis throughout the valuation
process.) Alternative uses that are currently financially feasible and those that are

forecast to be financially feasible can be compared through discounted cash flow
analysis, which is discussed in detail in Chapter 27.
Mixed Uses
Highest and best use often comprises more than one use for a parcel of land or an
improved property. A large tract of land might be suitable for a planned unit develop-
ment with a shopping center in front, condominium units around a golf course, and
one-unit residential sites on the remainder of the land. Business parks often have sites
for retail stores in front and warehouse or light manufacturing structures in the rear.
In these cases, different portions of the tract will have different highest and best uses.
One parcel of land may serve many functions. Timberland or pastureland may
also be used for hunting, recreation, and mineral exploration. Land that serves as a
right of way for power lines can double as open space or a park or may be used for
agricultural purposes. Public streets with railroad sidings can also be considered
mixed-use land.
A single building can have a mix of uses as well. A hotel may include a restau-
rant, a bar, and retail shops in addition to its guest rooms. A multistory building
may contain offices, apartments, and retail stores. A “single-family,” owner-occupied
home may, where permitted, have an upstairs or basement apartment.
If the highest and best use of a property is for more than one use on the same par-
cel or in the same building, the appraiser must analyze the contributory value of each
use. This testing can be accomplished by repeating the steps of marketability analysis
for each use to determine the timing and economic contribution of each use and there-
by be reconciled into a conclusion of the best economic mix of uses for the property.5
Special-purpose Properties
All properties are built for a specific use, but some properties are labeled special-
purpose properties when the features of the improved property are appropriate for only
a specific use or a limited number of uses, which may be costly to modify to another
use. The highest and best use of a special-purpose property as improved is probably
the continuation of its current use if that use remains viable and there is sufficient
market demand for that use. The highest and best use analysis would likely include
some forecast of continued economic demand.
If the current use of a special-purpose property is physically, functionally, or
economically obsolete and no alternative uses are feasible, the highest and best use of
the land might be realized by demolishing the structure and selling the remains for
their scrap or salvage value, if possible. This may be true even if the improvements
are relatively new and they were costly to build. For example, a ten-year-old fire sta-
tion would have been designed for one use, and the owner of the property is the only
user of the real estate put to that use.
5. For an example of the process of highest and best use analysis for a mixed-use property, see Stephen Fanning, Market Analysis for Real Estate,
2nd ed. (Chicago: Appraisal Institute, 2014), 547-552. The example illustrates a mixed-use site, but the analysis of a mixed-use building would
follow similar procedures.

Land and Site Valuation 19
Land has value because it provides potential utility as the site for a structure, recre-
ational facility, agricultural tract, right of way for transportation routes, water stor-
age, or other use. Land may also have value when valuable minerals (e.g., oil, coal,
gravel, sand, iron ore) can be extracted from it. In some locales, the ability to extract
water from a site is very valuable, and the legal right for its use may dwarf all other
forms of utility. In other areas, the ability to build in the air space above a parcel of
land may have as much or more value than the potential uses of the surface or sub-
surface of the land. In sum, if land has utility for a specific use and there is demand
for that use, then the land has value to a particular category of users. Use characteris-
tics and demand are not static and will vary over time and under changing economic
conditions. Beyond the basic utility of land, however, many principles and factors
must be considered in the process of land valuation.
Relation to Appraisal Principles

The appraisal principles of anticipation, change, supply and demand, substitution,
and balance all influence land value. Anticipation means that value is created by the
expectation of benefits to be derived in the future. For example, if buyers anticipate
that land in a certain location will be in demand for office use within the next five
years, they may be motivated to acquire land for future development even though
the development of office space is not presently feasible. The competition among the
buyers in the market for land creates a price level for the land that may have little to
do with the current use.
In comparison to most commodities, the supply of land is relatively stable.
Although vast changes have occurred in the earth’s surface over the ages and slight
modifications in the supply and quality of land may occur over time, these changes
usually occur over such a long term that their effects are imperceptible in real estate
markets. There are, however, a few notable exceptions to the permanence of land,
such as the accretion or erosion of land along a shoreline, the pollution of land with
harmful wastes, the exhaustion of agricultural land through improper farming meth-
ods, and the transformation of arable land into arid land due to ecological imbalances
or climate change. Earthquakes may change the surface of the earth, faults beneath the
surface can create vast sinkholes, and old underground mines can cause subsidence.
The principle of substitution, which holds that a buyer will not pay more for one
property than for an equivalent property, applies to raw land and developable sites
just as it does to improved property. The principle of substitution indicates that the
greatest demand will be generated for the lowest-priced site with similar utility.
The principle of balance is also applicable to the value of land. When the various
elements of a particular economic mix or a specific environment are in a state of equi-
librium, the demand for land is sustained. When the balance is upset, demand may
decrease and values change. For example, if an industrial district has too much industri-
ally zoned land and a declining number of industrial users, then the demand for indus-
trial land will probably fall. On the other hand, if the industrial district is in transition to
other, more profitable uses and there is a reasonable probability of a zoning change, the
value of a particular site could be higher than the value for continued industrial use.
Property Rights and Public Controls

The analysis of the value of a parcel of land focuses on the physical parcel and the
accompanying property rights. These rights may include the right to
• Develop the land to its highest and best use
• Lease the land to others
• Farm the land
• Mine the land
• Alter the land’s topography
• Subdivide the land
• Assemble the parcel of land with other parcels
• Hold the land for future use
• Construct or alter building improvements
• Reserve the land in perpetuity via an easement, donation, or sale to a nonprofit
or government entity
Whenever possible, appraisers consult title reports, public records, or available land
survey information to identify easements, rights of way, and private or public restric-
tions that affect the subject property.
In an effort to encourage planned growth and compatibility among different land
uses, governments regulate how land can be used. Most municipalities and coun-
ties have some form of land use regulations that specify how a parcel of land can be
developed. In addition to land use regulation, many jurisdictions have master plans
or comprehensive land use plans that specify long-term development goals. Fre-
quently, real estate developers must have amenities such as open space, streets, and
off-site public improvements in place or dedicated before a proposed development
receives approval from the appropriate public agency. Development can proceed
only after detailed development plans have been submitted and zoning and building
department approvals have been obtained. In many areas, citizen groups will protest
a development that they do not like, and their objections can influence the type of

development that is finally approved and the cost and time required to get approvals.
In some jurisdictions, the time, effort, and costs to obtain approvals are significant.
Typically, the value of the land increases after formal site plan approval has been
achieved and permits have been obtained for a development. At that point, the site
has full entitlements and is ready for development.
Through the power of eminent domain, the government can acquire land from
the private sector to be used for public and sometimes non-public projects, to aug-
ment the supply of public land, and to encourage economic development or elimi-
nate blight in a specific area.1
In some jurisdictions, transferable development rights can greatly affect the value
of land. In urban areas, development rights can be valuable, and discrete markets
have formed in which these rights are traded. In some rural areas, government
agencies compensate farmers for retaining land in agricultural use, and the agencies
then shift or sell the benefit of those development rights to other locations. Lower ad
valorem taxes on agricultural land also affect rural land use. This form of tax subsidy
tends to extend the duration of agricultural uses.
A trend in the United States has been the acquisition of land through open space
or conservation easements that are held in perpetuity by qualified agencies. These
permanent encumbrances limit or prohibit the development potential of land. The
potential uses of land subject to perpetual open space or conservation easements are
usually restricted, as specified in the deed of easement, and thus the value of the land
is affected. Open space can also be preserved through the qualified donation of speci-
fied easement rights to a qualified recipient such as a land trust.
Water, mineral, and air rights are also important considerations in land valuation.
Water rights cover the flow of water, usually for stated times and in stated quanti-
ties, for irrigation and hydroelectric power generation. Water rights also can take the
form of riparian rights which, under common law, grant a landowner the ownership
of waters that share a border with the owner’s parcel of land. Mineral rights cover
the underground portion of the land and usually refer to the right to extract under-
ground minerals or to use underground caverns or reefs for storage. The valuation
of mineral rights usually requires specialized research, but appraisers need to under-
stand if mineral rights are to be included or excluded from the valuation. Real estate
developments established on air rights, often over railways, can be found in older
urban areas, particularly where the density of the built environment is already high
and little land is available for new construction.
Physical Characteristics and Site Improvements

In the common parlance of valuation, land becomes a site when the parcel of land is
improved and ready to be used for a specific purpose. The physical characteristics
of a site, the utilities available, and any site improvements affect the use and value
of the land. The physical characteristics of a parcel of land that an appraiser must
consider include
• Size
• Shape
1. The taking of private land through condemnation for economic development, and particularly for private sector development, has come under
greater public scrutiny since 2005 when the US Supreme Court issued its decision in Kelo v. City of New London.

• Frontage
• Soils
• Location
• View
• Topographical characteristics such as contour, grade, and drainage
A site may have both on-site and off-site improvements that make it suitable for
its intended use or for new construction. The availability of water, sewers, electricity,
natural gas, and telephone and data lines also influences the use and development
potential of a parcel of land. (See Chapter 12.) On-site improvements are subject to
physical deterioration and functional obsolescence like buildings and other struc-
tures when the site is valued as improved. Off-site improvements may have an effect
on the value of a site, even though they are not a part of the site.
Highest and Best Use

The valuation of land draws directly from the conclusions of highest and best use
analysis. Even if a site is already improved, the site is valued as though vacant and
available for development to its highest and best use. Consideration of the site as
though vacant facilitates the orderly analysis and solution of appraisal problems that
require land to be valued separately. The highest and best use of a competitive site on
the date of sale is the basis of the comparability of that site to the property being ap-
praised. Regardless of how physically similar a potentially comparable site is to the
subject site, the most comparable sales would have the same or a similar highest and
best use. Markets without recent sales of comparable sites are problematic and may
require analysis of competing sites where sufficient data are available or alternative
land valuation methods may be considered.
The highest and best use of the property as improved is affected by how much
the existing improvements contribute to the value of the property as a whole. The
value contribution of the improvements can be estimated by subtracting the market
value of the site from the market value of the property as improved. Site value may
be equal to or greater than the value of the property as improved even when substan-
tial improvements are located on the site. Any penalty for the misuse of the site is
applied to the improvements. Demolition of existing improvements is usually appro-
priate when those improvements do not contribute to the overall property value. In
that situation, the cost of converting the property into vacant land is deducted from
the value indication for the site.
Sometimes the highest and best use of a property is to keep the land vacant until
land values rise to support new development. In that situation, the most appropriate
comparable properties would be other vacant sites being held for future develop-
ment for similar uses.
Excess and Surplus Land

As first discussed in Chapter 12, excess land is land that is not needed to support
the improvements and may be sold off separately from the rest of the property at its
own highest and best use. An area of excess land may have a different highest and
best use from the rest of the site, which must be addressed in the highest and best use
analysis by testing alternate uses of the excess land for physical possibility, legal per-
missibility, financial feasibility, and maximum productivity in the market. Further-

more, excess land has to be treated separately in the valuation process. An entirely
different set of comparable data may be required to analyze the value influences on
the excess land, and the appraiser must consider and report the contributory value of
the excess land to the value of the whole. Adding the value indication of the excess
land to the value indication of the rest of the property may or may not be appropriate
because the sum of the parts may or may not equal the value of the whole.
In contrast, surplus land does not have a separate value from the rest of the site be-
cause it cannot be sold separately. It is extra land that may or may not contribute value to
the overall property. Both surplus and excess land are extra meaning they are not needed
to support the improvements. However, excess can be sold off with its own highest and
best use whereas surplus land cannot. Surplus land may or may not have the same value
per unit of comparison (e.g., value per square foot, value per acre) as the rest of the site.
Applicability and Limitations of Valuation Techniques

Sales comparison is usually the preferred method for developing an opinion of site
value. When this method is used, most of the techniques for selecting comparable
sales and making adjustments that are described in Chapter 20 can be applied to site
valuation. When there are not enough sales of similar parcels for the application of
sales comparison, alternative methods such as market extraction, allocation, land
residual analysis, and various income capitalization techniques may be used.
Sales Comparison
Sales comparison may be used to value land that is actually vacant or land that is
being considered as though vacant for valuation purposes. Sales comparison is the
most common technique for valuing land, and it is the preferred method when com-
parable sales are available. To apply this method, data on sales of similar parcels of
land is collected, analyzed, compared, and adjusted to provide a value indication for
the site being appraised. In the comparison process, the similarity or dissimilarity of
the parcels is considered.
Appraisers perform several tasks in developing an opinion of site value:
• Identify the highest and best use and other characteristics of each potential com-
parable sale and then choose the appropriate properties for analysis.
• Gather data on actual sales as well as listings, offers, and options.
• Identify the similarities and differences in the data.
• Identify units of comparison that explain market behavior.
• Adjust the appropriate unit prices of the comparable sales to account for the dis-
similar characteristics of the land being appraised.
• Form a conclusion as to the value of the subject site.
The objective of sales comparison is to select the most comparable sales and then
adjust the comparable sales for differences that cannot be eliminated within the selec-
tion process. Elements of comparison may include property rights, financing terms,
conditions of sale (motivation), expenditures immediately after purchase, market condi-
tions (changes over time), location, physical characteristics, economic characteristics,
available utilities, and zoning. The physical characteristics of a parcel of land include,
but are not limited to, its size, shape, frontage, topography, soil conditions, location, and

Table 19.1 Applicability and Limitations of Land Valuation Methods
Sales Comparison
Procedure Sales of similar, vacant parcels are analyzed, compared, and adjusted to provide a value indication for the
land being appraised.
Applicability Sales comparison is the most common technique for valuing sites, and it is the preferred method when
comparable sales are available.
Limitations A lack of sales and the comparability of the available data may weaken support for the value estimate.
Market Extraction
Procedure An estimate of the contributory value of improvements is deducted from the total sale price of a property to
arrive at an indicated land value for the comparable. The indicated land values of the comparables are then
compared to provide a value indication for the land being appraised.
Applicability This technique is most applicable when the contribution of the improvements to total property value is
generally small and relatively easy to identify. (The technique is frequently used in rural areas.)
Limitations The appraiser must be able to determine the value contribution of the improvements.
Allocation
Procedure A ratio of site value to property value is extracted from comparable sales in competitive locations and applied
to the value of the improved subject property or comparable properties to develop the site value.
Applicability This technique is applicable when
• Valuing one-unit residential lots where ample sales of improved properties are available and the ratio of
site value to improved property value can be supported. This method tends to be less accurate for com-
mercial properties, especially when the number of vacant land sales is inadequate.
• For commercial properties or where relatively few sales are available, allocation can provide a test of
reasonableness rather than a formal opinion of site value.
Limitations The allocation method does not produce conclusive value indications unless ample sales data is available.
The method is rarely used as the primary land valuation technique for properties other than residential
subdivision lots. Also, land-to-property value ratios can be difficult to support.
Procedure The net operating income attributable to the land is capitalized or the cost to construct an improvement is
deducted from the value as if completed to produce an indication of the land’s contribution to the total property.
Applicability This technique is applicable in the financial analysis of alternative uses of a particular site in highest and
best use analysis and when land sales are not available.
Limitations When used as an income capitalization technique, the following conditions must be met:
1. Building value is known or can be accurately estimated.
2. Net operating income to the property is known or can be estimated.
3. Both building and land capitalization rates are available from the market.
When using a cost-based technique, the appraiser must be able to determine the value contribution of the
improvements, estimated at their depreciated cost
Ground Rent Capitalization
Procedure A market-derived capitalization rate is applied to the ground rent of the subject property.
Applicability This method is useful when comparable rents, rates, and factors can be developed from an analysis of sales
of leased land or sales of unleased land for which the market rent can be credibly determined.
Limitations An adjustment to the value indication for property rights may be necessary.
Subdivision Development Analysis (Discounted Cash Flow Analysis)
Procedure Direct and indirect costs and entrepreneurial incentive are deducted from an estimate of the anticipated
gross sales price of the finished lots or units, and the net sales proceeds are discounted to present value
at a market-derived rate over the development and absorption period. If entrepreneurial incentive is not
deducted as a line-item expense, then the discount rate must reflect the full effect of any profit.
Applicability This technique is applicable when subdivision development is the highest and best use of the land and there
is market support for immediate absorption.
Limitations Discounted cash flow analysis requires significant amounts of data such as development costs, profit margins, sales
projections, and the pricing of developed lots or units, together with a supportable forecast of market absorption.
Note: Certain US states do not recognize subdivision development analysis as an acceptable valuation method for purposes of litigation valuation.

view. (For a detailed discussion of elements of compari-
son, see Chapter 21.) Unit prices may be expressed as Sales comparison is the
most commonly used
price per square foot, front foot, acre, lot, dwelling unit, method of valuing land. Data
floor area ratio (FAR), or other unit used in the market. on sales of similar parcels of
If sale prices have been changing rapidly over the land is collected, analyzed,
past several years and an adequate amount of sales compared, and adjusted to
data is available, the sales selected for comparison reflect the similarity or dis-
similarity of those parcels to
should take place as close as possible to the effective the subject property.
appraisal date. When current data on local sales is not
available, appraisers may need to expand the search to
another market area, which may call for an adjustment
for location, or extend the search back in time in the same market area, which usually
calls for an adjustment for market conditions. The decision to use sales from other
market areas or older sales should be based on which adjustment has more support—
the location adjustment or the market conditions adjustment.
Among generally similar sales, size may be less important as an element of com-
parison than date and location. Most land uses have an optimal site size. If the site is
too large, the value per unit of comparison for the surplus land tends to decline at an
accelerating rate. Because sales of different sizes may have different unit prices, ordi-
narily more weight is given to sales of comparable properties that are approximately
the same size as the subject property.
Zoning is a basic criterion in selecting comparable sites. Sites zoned the same as
the subject property generally have the same or a similar highest and best use and
may be the most appropriate comparable properties. However, zoning can be less im-
portant than utility or highest and best use in areas that are in transition or targeted
for redevelopment. If sufficient sales in the same zoning category are not available,
data from similar zoning categories can be used and adjustments may be necessary.
In addition to recorded sales and signed contracts, appraisers may consider offers
to sell (listings) and offers to purchase. However, offers generally provide less reliable
data than signed contracts and completed sales because they represent what a buyer
was willing to pay rather than the price both a buyer and seller were willing to agree
to consummate a sale. Also, appraisers may choose to use a recent sale of the subject
property as a comparable sale. For example, if the subject site sold 18 months ago for
$545,000 in a market that is increasing at 3% per year (on a straight-line basis, i.e., not
compounded), an appraiser could derive an indication of market value by adjusting
the prior sale for the changes in the market:
$545,000 × [1 + (1.5 × 0.03)] = $569,525
This assumes that the property has not changed physically since the prior sale, the pri-
or sale meets all the requirements of a market sale, and the prior sale occurred within
a reasonable period from the effective date of value. It also assumes that, during the
intervening period, the applicable zoning and land use regulations did not change.
Data on land sales is available from sources such as data services, online and
print publications, and deed and assessment records. Interviews with the parties in-
volved in transactions—i.e., the buyers, sellers, lawyers, and brokers—provide more
direct information and may reveal adjustments that should be made for conditions
of sale or sale concessions. The interviews should identify the buyer motivations and
planned use as well as the status of any approvals and entitlements.

After comparable data is collected and categorized, and the comparable proper-
ties are examined and described, sales data can be assembled in an organized, logical
manner. Sales are commonly arrayed in a market data grid that identifies the ele-
ments of comparison that may require adjustments. Appropriately developed adjust-
ments for significant differences between the subject property and the comparable
properties may be made to the sale or unit prices of the comparable properties using
a variety of techniques. (Techniques for making adjustments in sales comparison
analysis are discussed in Chapter 21.)
Generally, separate adjustments are made to the comparable sales for each element
of comparison. The magnitude of each adjustment is indicated by the data and the
judgment of the appraiser. If the data selected is not sufficient to support the required
adjustments, the appraiser should gather and analyze additional comparable data.
A sale price adjustment may be a precise dollar amount or percentage developed
from market evidence. Either way, the adjustments are the appraiser’s approximations
of the market’s reaction to the element of comparison. Adjustments can be totaled and
factored into the comparable sale prices as part of the initial data gathering process.
Typically, adjustments are made in a preferred order—i.e., transactional adjustments
for property rights, financing, and sale and market conditions are made before prop-
erty adjustments for location and physical characteristics. All adjustments should be
presented in the appraisal report in a logical and understandable manner. If specific
adjustments cannot be supported by market evidence, the comparative analysis of sale
prices can still help appraisers analyze a comparable property’s relative superiority or
inferiority to the subject property. This fine tuning can take place in the reconciliation.
Market Extraction
Market extraction is a valuation technique in which land value is estimated by deduct-
ing the contributory value of the improvements from the sale price of an improved
comparable property. The remainder represents an indication of the value of the land.
Improved sales in rural areas are frequently analyzed in this way because the building
and site improvements may contribute little value in comparison to the underlying land
value. The improvement contribution is typically small and relatively easy to quantify.
As an example, consider a vacant subject site in an area where few sales of compa-
rable sites have occurred recently. The sales summarized in Table 19.2 involve sites that
are similar to the subject property except for the improvements. The contributory value
of the improvements is subtracted from each sale price to calculate value indications for
the sites of the comparable properties (Table 19.3). Those value indications can, in turn,
be analyzed using sales comparison techniques and reconciled into a value indication
for the subject site. In this case, the value indications range from $407,000 to $435,000.
Allocation
The allocation technique is based on the principle of balance and the related concept
of contribution. Both affirm that there is a normal or typical ratio of land value to
property value for specific categories of real estate in specific locations. Meaning-
ful support for an allocation ratio may be derived from a variety of sources such as
observed patterns over time in an area and consultation with developers who sell
improved properties and can allocate sale prices between the land and the improve-
ments based on their costs.

Table 19.2 Comparable Sales for Market Extraction
Sale Sale Price Description
1 $450,000 Includes storage building that contributes $15,000
2 $465,000 Includes 1,500-sq.-ft. building with a contributory value of $32 per square foot
3 $432,000 Includes permits and entitlements for construction that contribute
$25,000 in value
4 $448,000 Includes a temporary sales building that contributes $32,000
Table 19.3 Market Extraction of Site Value

Sale 1 Sale 2 Sale 3 Sale 4
Sale price $450,000 $465,000 $432,000 $448,000
Less contribution of improvements - $15,000 - (1,500 × $32) - $25,000 - $32,000
Site value indication $435,000 $417,000 $407,000 $416,000
In situations where there is limited sales data, the allocation technique can be
used to establish approximate land value when the number of vacant land sales is
inadequate. For example, an appraiser could use allocation to value the site for a new
one-unit home in a large, newly developed subdivision where few sales of vacant
land have occurred but credible data from several recent sales of improved properties
is available. The sale prices of new homes in the development range from $275,000
to $315,000, and the developer reports that site values within the subdivision range
from 15% to 20% of sale prices. Based on these figures, the indicated range of value
for the sites would be from $41,250 to $63,000.
The most common application of allocation is in the analysis of sales of resi-
dential subdivision lots, where the appraiser can directly measure the ratio of site
value to total property value. Allocation is rarely used as the primary method of site
valuation for commercial properties because of the relatively large number of sales
needed to support a credible value opinion when many adjustments for transactional
and property differences are necessary. In addition, commercial properties may vary
widely in parcel size and intensity of use. Parcels that have more land than is neces-
sary for the existing improvements are also difficult to value using allocation.
The allocation technique, and sometimes the market extraction technique, can
be difficult to use in markets where the highest and best use and land value ratios of
comparable parcels are not similar to the subject property. For example, consider a
subject site that is zoned for commercial use but is improved with a residence. The
commercial land value is $500,000 and the improved property value is $550,000. In
this case, if the comparable sites did not have similarly high ratios of land value to
improvement value, the allocation and extraction techniques would give misleading
indications of value.

Land residual analysis involves producing an indication of the land’s contribution to
the total property by either (a) capitalizing the net operating income attributable to the
land or (b) deducting the cost to construct an improvement from the value of the sub-
ject property as if improved. By isolating the value contribution of the land, the land

residual technique serves as an essential tool in highest and best use analysis to test the
economic productivity of alternate uses of the site as though vacant. (See Chapter 18.)
As an income capitalization technique, land residual analysis requires that the
following conditions be met:
1. The building value of the subject property is known or can be accurately estimated.
2. Net operating income to the property is known or can be estimated.
3. Both building and land capitalization rates can be extracted from the market.
Small variations in any of these variables can result in a dramatic change in the land
value indication. (Chapter 30 discusses procedures for estimating building costs,
Chapter 24 discusses the development of income and expense estimates, and Chapter
25 discusses the extraction of land and building capitalization rates.)
To apply the land residual technique as an income approach analysis, the ap-
praiser first determines what actual or hypothetical improvements represent the
highest and best use of the site as though vacant. Then the net operating income (NOI
or IO) of the property is estimated from market rents and operating expenses as of
the date of the appraisal. Next, the appraiser calculates how much of the income is
attributable to the building and subtracts this amount from the net operating income.
The remainder is the residual income attributable to the land, which is capitalized at
a market-derived land capitalization rate to provide an estimate of site value.
As a simple example, suppose the subject property’s net operating income is
$150,000, the land capitalization rate is 5.5%, the capitalization rate for the building is
7.5%, and the value of the improvements is $900,000. The calculations of the residual
land value would be as follows:
Net Operating Income (IO) = $150,000
Income to the Building (IB) = Building Value (VB) × Building Capitalization Rate (RB)
Income to the Land (IL) = IO - IB = $150,000 - $67,500 = $82,500
Income to the Land $82,500
Site Value = =I /R = = $1,500,000
Land Capitalization Rate L L 0.055
As a cost-based technique, land residual analysis shares characteristics with mar-
ket extraction in that land value is estimated as the difference between the value of
an entire property and the value of the improvements on the property. However, the
extraction technique involves analysis of comparable sites, while land residual analy-
sis is focused on the subject property. That is, in the market extraction technique, land
values of comparable properties are calculated by subtracting the estimated value of
the improvements from the value of the land and improvements, with the resulting
indications of land values adjusted and applied to the subject property.
In contrast, in land residual analysis, a similar process is employed, although
rather than analyzing comparable properties, the subject property is analyzed on its
own. Specifically, the valuation of the project upon completion is estimated using
both income capitalization and sales comparison techniques, as appropriate, and
those value indications are reconciled. Then, the costs related to constructing the
improvements are deducted to arrive at an indication of the land value.
Income Capitalization Techniques

The various income capitalization procedures used to estimate land values rely on in-
formation that can be difficult to obtain. Therefore, these techniques are generally not

used as primary valuation techniques except in special situations such as subdivision
development analysis. Direct capitalization and yield capitalization techniques are
discussed in more detail in Chapters 25, 26, and 27, and examples of land valuation
using discounted cash flow analysis are shown in Chapter 28.
Ground Rent Capitalization

Ground rent is the amount paid for the right to use and occupy the land according to
the terms of a ground lease. Market-derived capitalization rates are used to convert
ground rent into market value. The basic calculations are straightforward, as shown
in the following example of a 1-acre plot leased for $2.25 per square foot with a
market-derived land capitalization rate of 5.5%:
Income to the Land (IL ) = Ground Rent × Land Area
Income to the Land (IL ) = $2.25 per sq.ft. × 43,560 sq.ft. = $98,010
Income to the Land $98,000
Site Value = =I /R = = $1,782,000
Land Capitalization Rate L L 0.055
The ground rent capitalization procedure is useful when an analysis of compa-
rable parcels of leased land indicates a range of rents and land capitalization rates.
However, it must be recognized that if the capitalization rate used in this analysis
is derived from sales of leased properties, the value indication resulting from this
analysis is a leased fee value, not a fee simple value. In order for this leased fee value
to be useful as an indication of the value of the fee simple interest in the land, an
adjustment for property rights may be necessary.
If the current rent and terms of a leased parcel corresponds to market rent and
terms for comparable leased parcels with similar highest and best uses then only a
property rights adjustment would be necessary. If the ground rent paid under the
terms of an existing contract on the subject property does not correspond to the pre-
vailing terms and market rent, the value estimate given the current ground rent must
also be adjusted for the difference in these terms to obtain an indication of the market
value of the fee simple estate. Ground leases can have different terms and escalation
clauses that affect the income stream, so appraisers should consider all the benefits
to the lessor during the term of a lease and any option periods and forecast when the
reversion of the property will take place.
If the capitalization rate used in the ground rent capitalization analysis is derived
from fee simple sales instead of leased fee sales, then the value indication would
be for the fee simple, and no property rights adjustment would be required to the
indicated value. For example, consider a parcel of land that sold six months ago for
$1 million. Shortly after the sale, the buyer found a tenant for a ground lease of the
property at a market rate of $65,000 per year, and the property was then sold to an
investor for $1.3 million. The indicated capitalization rate for the leased fee interest
in the property is 5.0% ($65,000/$1,300,000). Application of this capitalization rate to
the subject property would result in an indication of the leased fee value. However,
this information can also be used to extract an implied capitalization rate for the fee
simple interest—6.5% ($65,000/$1,000,000). This capitalization rate inherently reflects
the time, cost, risk, and entrepreneurial incentive involved in acquiring an unleased
parcel of land and getting it leased. In this case, applying the 6.5% capitalization rate
to the market rent of the subject property would result in a value indication for the
fee simple interest in the property. This example can also be used to illustrate the

magnitude of the property rights adjustment that would be applicable if the sale of a
leased fee site was used to assist in valuing a fee simple interest in land. In this case,
the indicated property rights adjustment would be -23% (1 - $1,000,000/$1,300,000).
Subdivision Development Analysis (Discounted Cash Flow Analysis)

Subdivision development analysis may involve tracts of residential, commercial, or
industrial land (or a mix of land uses) that are large enough to be subdivided into
smaller lots or parcels and sold to builders or end users.2 A planned subdivision can
create a more intense use of the property when zoning, available utilities, access, and
other influential elements are favorably combined.
As a tool in land valuation, subdivision development analysis is primarily used
to provide a bulk sale value for a group of subdivision lots, either proposed or exist-
ing.3 The technique can also be used to estimate the value of vacant land or finished
lots in a proposed subdivision development scenario. Subdivision development
analysis relies on discounted cash flow analysis and requires that the property have
a highest and best use for development consistent with the proposed development
plan in order to reflect the current value of the vacant land. The technique may also
be used to test several potential development scenarios in determining the highest
and best use of the site as though vacant.
Subdivision development analysis is most useful in developing a current opinion
of land value when the highest and best use of the land is for immediate develop-
ment at the time of the appraisal or when there is evidence of market demand to
support financially feasible subdivision development. Market analysis provides the
evidence necessary to support absorption estimates, retail proceeds, and other com-
ponents required to calculate land value using subdivision development analysis.
Valuing finished lots or units in a subdivision is a common assignment for real
estate appraisers, but subdivision development analysis is a complex procedure.
When there is sufficient, reliable market data, the subdivision development method
provides credible results. The technique is most useful for developing the bulk mar-
ket value of a group of subdivision lots or units, whether existing or proposed. The
method uses what is known as a bulk sale scenario to develop the value of all the lots
to one purchaser. The value indication is most persuasive when the sales comparison
method of estimating land value provides additional support.
In essence, the subdivision development method uses the yield capitalization
techniques of the income capitalization approach to perform a discounted cash flow
analysis. To use discounted cash flow analysis to estimate raw land value, appraisers
must thoroughly understand the land development process and all the factors influ-
encing the subject property’s market area.
The development of any project involves three phases:
• The permitting stage
• The construction stage
• The absorption stage
2. Subdivision development analysis can be applied to completed homes within a subdivision, condominiums, super pads, and other property types,
but in this chapter the focus is on finished lots or units within a subdivision.
3. For an in-depth discussion of subdivision development analysis, see Don M. Emerson Jr., Subdivision Valuation, 2nd ed. (Chicago: Appraisal
Institute, 2017).

Figure 19.1 Sample Income Capitalization Approach Timeline
Raw Land Value by Subdivision Analysis
As Is Raw Discount Future Proceeds
Land Value to Time Zero
Permitting Construction Absorption

Phase Phase Phase
Time Zero 6 Months 12 Months 18 Months 24 Months 30 Months

Source: Don M. Emerson Jr., Subdivision Valuation, 2nd ed. (Chicago: Appraisal Institute, 2017), 103.
Data on sales and costs for the finished lots or units must be available. The real estate
developer usually provides the necessary project information, including the subdivi-
sion plat, the costs of development, a feasibility, marketability, or absorption study, and
a schedule of retail lot prices. When the developer supplies the information, an apprais-
er has a responsibility to compare this information with other relevant market data. The
market data and all conclusions in the analysis are the responsibility of the appraiser.
Adequately supported development cost estimates and an adequate investiga-
tion of the available market demand needed to support the absorption of lots over
time are critical elements of subdivision analysis. In markets that are oversupplied or
experiencing an economic downturn, appraisers must not simply assume that market
demand will stabilize at some arbitrary point in the future. Future market conditions
and demand forecasts must be supported by relevant market data.
To estimate raw land value using the subdivision development technique for a
proposed development, an appraiser performs the following steps:
• Assess the highest and best use of the site (e.g., the mix and intensity of uses).
• Create or affirm a supportable subdivision development plan.
• Determine the timing and cost for approval and development (including all costs
and conditions of obtaining development entitlements during the permitting stage).
• Forecast a schedule of retail lot prices or values over the absorption stage.
• Critically review available data as necessary to forecast the lot absorption and
price mix using inferred or fundamental demand and supply analysis (including
properly supported projections of community or market growth over the absorp-
tion period).
• Estimate a market-supported timeline for the permitting, construction, and ab-
sorption phases.
• Forecast holding costs as well as marketing and related sales expenses over the
permitting, construction, and absorption period.
• Estimate the annual real estate taxes and any other miscellaneous expenses over
the three stages of development.
• Consider management supervision or administrative costs as part of develop-
ment expenses.
• Choose an appropriate, market-supported discount rate.

This process can be modified to account for a date of valuation after the preliminary
permitting phase of the development process even further along the timeline (see
Figure 19.2).
In simplified form, an appraiser begins the analysis of a subdivision develop-
ment by determining the number and size of the lots that can be created on the
appraised parcel of land physically, legally, and economically. The proposed lots
must conform to jurisdictional and zoning requirements with regard to size, front-
age, topography, soil quality, and off-site improvements (e.g., water facilities, drain-
age, sewage, streets, curbs, and gutters). The lots must also meet the demands of the
market in which the property is located. Without surveys and engineering studies, an
appraiser cannot know exactly how many lots can be created from a particular parcel
of land. Simply multiplying the allowed density by the site size will not necessarily
indicate the number of lots that will be approved on the site, due to setback require-
ments and other restrictions. The extent of analysis performed may relate to the scope
of work of the appraisal assignment. A reasonable estimate of the number of potential
lots can often be deduced from zoning information, subdivision ordinances, and the
number of lots or typical unit density reflected in similar subdivision developments
in the subject’s market area. Allowances must also be made to account for the land
needed for streets, green space, water retention facilities, and any common areas.
If available, a preliminary development plan for the hypothetical subdivision of
the vacant land being appraised will specify much of the data an appraiser needs:
• Number and size of the lots
• Land development or construction work to be accomplished
• Direct (hard) and indirect (soft) construction costs
Figure 19.2 Sample Value Pattern of a Proposed Project

Typical Value Pattern—Proposed Project
Sum of
Retail Values
Holding and Sales Costs and
Profit over Absorption Period
Bulk Sale
Value
Value
Date of
Land PV of Value
Value Net Proceeds
Construction Absorption
Phase Phase
Time Zero 3 Months 6 Months 9 Months 12 Months 15 Months 18 Months

Time
Source: Don M. Emerson Jr., Subdivision Valuation, 2nd ed. (Chicago: Appraisal Institute, 2017), 105.

• Probable time required to subdivide the land and construct the on-site and off-
site infrastructure
• Expenses and holding costs that will be incurred during the relevant stages of
development
The appraiser then undertakes a marketability study to assess the supply and
demand situation and the probable capture and absorption rates to produce a sup-
portable absorption forecast for the lot inventory. Well-supported forecasts of product
demand and competitive supply can increase the credibility of the absorption forecast.
They are critical to the analysis because the raw land value can vary widely depend-
ing on the rate at which finished lots will be absorbed over time. The appraiser esti-
mates the projected retail prices of the lots by applying the sales comparison method.
The next step in subdivision development analysis requires a forecast of income
and expenses associated with the permitting, construction, and eventual sellout or
absorption of the finished lots over time. The time period used for the analysis ends
when the last lot is sold. Depending project size, sales velocity, and derivation of the
discount rate, annual, semiannual, or quarterly discounting periods are commonly
used. The projection period begins with the property in its current condition and, if
permitting is required, will include the time frame needed to achieve permitting, con-
struction, and the absorption of all lots. If permitting is already in place as of the date
of valuation, then the time period considered in the discounting calculation consists
of the construction and absorption phases only. The net cash flows from each period
are discounted to time period zero to arrive at a present value of the net proceeds,
which is an indication of the value of the property at that point in time.
Banking regulators and examiners like subdivision development analysis
because it provides transparency on the inputs used as the basis of the valuation. In
economic downturns, the number of sales of bulk finished lots are limited and regu-
lators may require lenders (as appraisal clients) to instruct appraisers as an assign-
ment condition to include a discounted cash flow analysis for the bulk lot holding.

The Sales Comparison Approach 20
In the sales comparison approach, appraisers develop opinions of value by analyzing

closed sales, pending sales, active listings, and cancelled or expired listings of proper-
ties that are similar to the property being appraised. The comparative techniques of
analysis applied in the sales comparison approach are fundamental to the valuation
process. Estimates of market rent, expenses, land value, construction cost, deprecia-
tion, and other value parameters may be derived in the other approaches to value
using comparative techniques. Similarly, in applying the sales comparison approach
appraisers often analyze conclusions derived in the other approaches to determine
the adjustments to be made to the sale or listing prices of comparable properties.
In the sales comparison approach, an opinion of market value is developed by
comparing properties similar to the subject property that have recently sold, are
listed for sale, or are under contract (i.e., for which purchase offers and a deposit
have been recently submitted). A major premise of the sales comparison approach is
that an opinion of the market value of a property can be supported by studying the
market’s reaction to comparable and competitive properties.
Comparative analysis of properties and transactions focuses on similarities
and differences that affect value, called elements of comparison, which may include
variations in property rights, financing terms, conditions of sale, market conditions,
locational influences, and physical characteristics, among others. Appraisers examine
market evidence using paired data analysis, trend analysis, statistics, and other
recognized and accepted techniques to identify which elements of comparison within
the data set of comparable sales are responsible for value differences.
This chapter focuses on the theory and concepts underlying the sales comparison
approach. Chapters 21 and 22 further the discussion with a deeper examination of
the methodologies employed by appraisers to analyze comparable sales and sample
applications of sales comparison techniques.
The concepts of anticipation and change—which underlie the principles of supply and
demand, substitution, balance, and externalities—are basic to the sales comparison
approach. Guided by these principles, appraisers consider all issues relevant to the
valuation problem in a manner that is consistent and reflects local market conditions.
Supply and Demand

Property prices result from negotiations between buyers and sellers. In a market with
many buyers and sellers, buyers make up the market demand and the properties
offered for sale or lease currently or in the foreseeable future make up the supply.1 To
estimate demand, appraisers consider the number of potential users of a particular
type of property, their purchasing power, and their tastes and preferences. To analyze
supply, appraisers focus on existing properties that are available on the market as
well as properties that are being constructed, converted, or planned.
Shifts in any of these factors may cause the prices of properties in the market area
to vary. The financial markets, government policies, and lenders also influence sales
activity because many real estate purchases involve some form of financing, which
affects purchasing power. When interest rates drop, market activity tends to accel-
erate and prices tend to rise because buyers qualify for higher mortgage amounts.
When interest rates rise, market activity tends to slow down and prices tend to
fall because buyers do not qualify for loans at the previous levels. When mortgage
money becomes scarce, either due to higher interest rates or restrictive underwriting
standards, market activity can be severely reduced. The inability of buyers to obtain
affordable financing is an impediment to additional demand in most markets.
Substitution
The principle of substitution holds that the value of property tends to be set by the
cost of acquiring a substitute or alternative property of similar utility and desirability
within a reasonable amount of time.
Balance
The forces of supply and demand tend toward equilibrium, or balance, in the mar-
ket, but absolute equilibrium is almost never attained. Due to shifts in population,
purchasing power, consumer tastes and preferences, and many other factors, demand
varies greatly over time. The construction of new buildings, conversion of existing
buildings to other uses, and demolition of old buildings cause supply to vary as well.
The principle of balance also holds that both the relationship between land and
improvements and the relationship between a property and its environment must be in
balance for a property to achieve its optimum market value. For example, a residential
property with a one-car garage in a market that expects similar homes to have a two-car
garage (known as an underimprovement) or too many expensive amenities for its location
(known as an overimprovement or superadequacy) is out of balance. Appraisers must watch
for imbalances in the market and within specific properties because those imbalances can
1. Market value is based on conventional economic theory, which predicts a unique market-driven price at the point where supply equals demand in
a competitive market. Even in a monopoly, with only one seller, or a monopsony, with only one buyer, a unique price is predictable. But as soon
as the market consists of only one seller and one buyer, called bilateral monopoly, economic theory can no longer predict a unique price. Bilateral
monopoly theory predicts a minimum sale price and a maximum sale price, but no unique price, and suggests that any observed transaction
price depends not on supply and demand but on the negotiating or bargaining skills of the buyer and the seller.

cause the market to ascribe different prices to otherwise comparable properties. Overim-
provements and underimprovements can lead to functional obsolescence that may need
to be accounted for in sales comparison, income capitalization, and cost approach analy-
ses. They also can be a key factor in determining which sales are the most comparable.
Externalities
External forces affect all types of property in positive or negative ways. Periods of
economic growth and economic decline influence property values. Appraisers ana-
lyze the market area of the subject property to identify all significant external influ-
ences. To a great extent, the adjustments made to the sale prices of comparable prop-
erties for differences in location reflect these external forces. That is, two competitive
properties with identical physical characteristics may have quite different market
values if one of the properties has less attractive surroundings. The condition and
lighting of streets, the convenience of transportation facilities, the adequacy of police
protection, the enforcement of municipal regulations, real estate tax burdens, and the
proximity to shopping and restaurant facilities can all vary with location, making one
location more or less attractive than another.
Market Analysis and Highest and Best Use

The conclusions of market analysis and highest and best use analysis are fundamen-
tal to the sales comparison approach. Analyzing the subject property’s highest and
best use and market area helps appraisers identify and analyze the competitive sup-
ply and demand factors that influence value in the market. In addition, an adequately
supported determination of the subject property’s highest and best use provides the
basis for the research and analysis of comparable sales, answering questions such as
• Which comparable properties have the most similar highest and best use to the
subject property?
• Do the improvements contribute value to the comparable property?
• Is the comparable property as improved an interim or transitional use?
• How much time must pass before development (or redevelopment to an alterna-
tive use) is feasible on the unimproved subject and comparable properties?
• Who is the likely user of the comparable property?
Applicability and Limitations

The sales comparison approach is applicable to most types of real property interests
when there are sufficient recent, reliable transactions to indicate value patterns or
trends in the market. For property types that are bought and sold regularly, the sales
comparison approach often provides a credible indication of market value. When
data is available, sales comparison can be the most straightforward and simple way
to explain and support an opinion of market value.
If the appraisal assignment is to develop an opinion of market value but no sales
are available, appraisers must question what type of market actually exists for the
subject property. The common definitions of market value all presume a sale of the
subject property, which implies the existence of a market. The market for a specific
property may not be for the property as it is currently improved or configured or
was originally intended to be used. For example, in most markets a parcel of land

improved with a building that formerly served as the
The sales comparison county jail is unlikely to attract a buyer as presently
approach is applicable
when sufficient data on improved, so the market value would be what a typical
recent market transactions buyer would pay for the land (less demolition costs) or
is available. If no sales are for any economic use to which the building could be
found, appraisers may have converted. The existence of a market should be consid-
to use other approaches to ered with many special-purpose properties.
value but only after they are
convinced that there actually Typically, the sales comparison approach pro-
is a market for the property. vides a credible indication of value for commercial
Information derived through and industrial properties suited for owner occupancy,
sales comparison may be i.e., properties that are not purchased primarily for
used in the income capital- their income-producing characteristics. These types
ization and cost approaches.
of properties are generally suitable for application of
sales comparison because similar properties are com-
monly bought and sold in the same market.
Buyers of income-producing properties usually concentrate on a property’s
economic characteristics and typically put more emphasis on the conclusions of the
income capitalization approach. Thoroughly analyzing the leased fee in comparable
sales of large, complex, income-producing properties can be difficult because infor-
mation on the economic factors influencing the decisions of market participants may
not be readily available from public records or interviews with buyers and sellers. For
example, an appraiser may not have sufficient knowledge of all the existing leases
applicable to a neighborhood shopping center that is potentially comparable to the
subject property. The sale of a property encumbered by a lease involves rights other
than the complete fee simple estate, and valuation of those rights requires knowledge
of the terms of all leases and an understanding of the tenant or tenants occupying the
premises. In most cases, when real estate sells with leases in place, the new owner in-
herits the leases. If the leases are set at rental rates and terms below what the current
market rental rate and terms are, the value to investors would be less than the value
of a similar property that has higher net income with similar upside potential. Any
difference must be compensated for if it exists. If the lease with submarket rents has a
term with only a few months remaining, that difference may be negligible.
Some transactions may include the transfer of other physical assets or business in-
terests in the sale. In each instance, if the sale is to be useful for comparison purposes,
it must be dissected into its various components. One of the most reliable methods for
identifying the components of value is to interview the buyer. Even when the compo-
nents of value can be allocated, the sale may be less reliable as an indicator of the mar-
ket value of the real property because of the complexity of the mix of factors involved.
At times the use of the sales comparison approach may be limited, but the
analysis of comparable sales, pending sales, active listings, and cancelled or expired
listings can still be a significant and essential part of the valuation process. Although
appraisers cannot always specifically identify and quantify how the factors affect-
ing property value are different, they can still analyze comparable sales to assist in
supporting the conclusions of the other approaches, i.e., to develop a bracket for the
value indications derived from the cost and income capitalization approaches. In
addition, the analysis of comparable sales can provide information used in the other
approaches such as overall capitalization rates for the income capitalization approach

or depreciation estimates for the cost approach. Income multipliers, capitalization
rates, and yield rates are applied in the income capitalization approach to value, but
these rates and factors are often extracted from comparable properties.
Procedure
To apply the sales comparison approach, appraisers follow a systematic procedure:
1. Research the competitive market for information on properties that are similar to the
property being appraised and that have been sold recently, or were listed for sale,
or are under contract. Information on agreements of sale, options, listings, and bona
fide offers may also be collected. The characteristics of the properties such as prop-
erty type, date of sale, size, physical condition, location, and land use constraints
should be considered. The goal is to find a set of comparable sales or other evidence
such as property listings or contracts as similar as possible to the subject property
to ensure they reflect the actions of similar buyers. Market analysis and highest and
best use analysis set the stage for the selection of appropriate comparable sales.
2. Verify the information by confirming that the data obtained is factually accurate
and that the transactions reflect arm’s-length market considerations. Verification
should elicit additional information about the properties such as buyer and seller
motivations, economic characteristics (if the property is income-producing),
value component allocations, and other significant factors as well as information
about the market to ensure that comparisons are credible.
3. Select the most relevant units of comparison used by participants in the market
(e.g., price per acre, price per square foot, price per front foot, price per dwelling
unit, price per lot or proposed lot, price per room) and develop a comparative
analysis for each unit. The goal is to define and identify a unit of comparison that
explains or mirrors market behavior.
4. Look for differences between the comparables being considered and the subject
property using all appropriate elements of comparison. Then adjust the price of
each comparable, reflecting how it differs to equate it to the subject property or
eliminate that property as a comparable. This step typically involves using the
most similar properties and then adjusting for any remaining differences. If a
transaction does not reflect the actions of a buyer who would also be attracted to
the subject property, an appraiser should be concerned about comparability and
the wisdom of relying on that comparable as a basis for comparison.
5. Reconcile the various value indicators produced from the analysis of compa-
rables into a value indication from the sales comparison approach. A value can be
expressed as a single point estimate, as a range of values, or in terms of a rela-
tionship (e.g., more or less than a given amount).
Researching Transactional Data

In the first step of the sales comparison approach, appraisers gather data on sales, list-
ings, contracts, offers, refusals, and options relating to properties considered competitive
with, and comparable to, the subject property. Appraisers must thoroughly research the
prices, real property rights conveyed, financing terms, motivations of buyers and sellers,
expenditures made immediately after purchase, and dates (i.e., the market conditions) of
the property transactions or contracts. Appraisers must also consider each property’s lo-

cation, physical condition, functional utility, economic characteristics, use, and non-realty
components. Appraisers should not select comparables based strictly on price, as other
factors must be considered when assessing comparability. Because conclusions must
be market-derived, appraisers will rely heavily on interviews, personal contacts, and
proprietary research. Personal verification with a party to the transaction is an important
step in the sales comparison approach and it may be a client requirement, depending on
the type of assignment. Verifying data is discussed in a later section of this chapter.
Regardless of the number of properties analyzed, appraisers must understand
each comparable property used for comparison to draw credible conclusions. For ex-
ample, the conditions of sale in a transaction of real property between family members
may not be consistent with the definition of market value. In another sale of a compa-
rable property, the buyer may have had motivations that resulted in paying more than
market value. It may be possible to determine the relationship between the reported
sale price and market value only after research into the characteristics of the sale, the
property, and the market for that property. Properties that cannot be effectively used
for direct comparison are still part of the market at large and can be used for under-
standing general market activity and other analytical purposes. Thus, market data is
classified and weighted for its importance, relevance, and reliability.
Changing market conditions may reduce the applicability of older sales that do
not reflect the current market. Trends indicated by changing market conditions can
be useful, but appraisers must be careful not to project trends without current, reli-
able market support specific to the subject property or property type (e.g. residential
condominiums, new construction, office, retail, hospitality). Historical sales are valu-
able in retrospective valuations and may assist in time series analysis. However, sig-
nificant changes in market conditions make the use of historical sales less reliable for
current valuations unless a supportable conclusion regarding the changes between
the time periods is applied. Appraisers must look for possible changes that may be
imposed on the market, thus changing the applicability of historical data. Also, some
sales may reflect the anticipation of change and may be evidence of market attitudes
in advance of the actual change. The availability and terms of financing are also im-
portant in the analysis of comparable sale properties in the market.
As explained in Guide Note 11 of the Guide Notes to the Standards of Profession-
al Practice of the Appraisal Institute, it may be necessary to expand the geographic
search area for comparable sales in markets where there have been few sales or to re-
search sales further back in time. It is also important to determine a class or subclass
of sales that dominate the market. For example, during periods of severe economic
downturns, REO sales or foreclosures may dominate the market.
The geographic limits of an appraiser’s search for sales data depend on the nature
and type of real estate being valued and the available sales information. Certain types
of properties have regional, national, and even international markets. For example, a
Class A, high-rise office building in a central business district that would appeal to a real
estate investment trust may sell in a regional or national market, but a six-unit apart-
ment building in a typical neighborhood would not. These properties would need to be
compared to completely different properties and using the two as comparable proper-
ties is inappropriate. As another example, an appraiser may find little comparable data
for a property that is the first to be renovated in an area of deteriorated buildings or for
the only property of a given type in a market area. In this situation, the appraiser must

establish the comparability of other areas and the competitiveness of the properties
located in these areas with the subject property. Similarly, appraisers may gather data
from a wide geographic area to find competitive properties for a regional shopping mall,
large office building, resort hotel, large multiuse complex, or large industrial property.
In addition to sales of competitive properties, prior sales of the subject property
must be considered in market value appraisals. The Uniform Standards of Professional
Appraisal Practice (USPAP) require appraisers to analyze and report all agreements of
sale, options, and listings of the subject property current as of the effective date of the
appraisal and to analyze all sales of the subject property that occurred within the three
years prior to the effective date of the appraisal. Other valuation standards such as the
Uniform Appraisal Standards for Federal Land Acquisitions require that appraisers
report an even longer sales history. However, it is not sufficient to simply report the
subject property’s sales history. In fact, simply reporting prior sales does not meet the
USPAP requirements on this issue. When an opinion of market value is to be devel-
oped, appraisers must analyze all sales of the subject property that occurred in the three
years prior to the date of value. Appraisers must also analyze any agreements of sale
(contracts), options, and listings that are current as of the effective date of appraisal.2
The sales history required by various sets of valuation standards is a minimum
requirement. Ideally, appraisers would consider all relevant historical sales data from
which market conditions could be analyzed. If the information is not available, an
appraiser must explain the efforts taken to uncover it. This analysis is particularly
significant when the comparable sales are limited and are either vastly superior or
inferior to the subject property. When the information is available, an appraiser may
want to present a chart of the subject property’s sales, contracts, listings, and offers in
the sales comparison analysis alongside information on the comparable sales.
USPAP has no requirement to analyze the sales history of each comparable sale.
However, Fannie Mae and certain other government bodies require comparable sales
histories. This regulation is applicable to lenders, and it is reflected on the standard
residential appraisal report form. These requirements are assignment conditions
based on the intended use and intended user.
Data Independence
Appraisers strive to collect information about the sales that best reflect the market demand for the subject
property because a pool of the most representative data will yield the most accurate insights into the value
of a property and the magnitude of property adjustments. When appraisers derive all adjustments using a
limited data set, a single erroneous sale price or figure in that data set can cause errors in the adjusted sale
prices of all the comparable sales, leading to an erroneous indication of value for the subject property. In this
situation, the independence of the sales data is lost.
Verifying data will help eliminate the erroneous data that can have an injurious effect on adjustment amounts
and ultimately the value indication. A practical technique for retaining the independence of the data is to de-
velop adjustment amounts using data from outside the data set, which may require additional market research.
The larger the number of adjustments made within a small data set, the greater the probability that the
results of the analysis will be affected by data collection errors. Of course, transactional and property data
should be checked for errors that could affect the conclusions of the sales comparison approach.
2. See Standards Rule 1-5, the reporting requirements in Standards Rule 2-2, and Advisory Opinion 1: Sales History in the Uniform Standards of
Professional Appraisal Practice. Note that USPAP requirements apply to US appraisers. Market and regulatory requirements exist in other countries
as well. For valuations outside the United States, practitioners should research local requirements and expectations.

It is imperative that appraisers identify and analyze the strengths and weakness-
es of the quantity and quality of the data compiled and the extent of the comparative
analyses undertaken in the sales comparison approach. Appraisers must consider
all relevant facts in their analyses and report them in the amount of detail required
given the intended use of the appraisal as identified in the scope of work.
Data Sources
Primary sources of sales data include
• Public records (e.g., courthouse records, government sales tax records, assessors’
records)
• Commercially available data from multiple listing and subscription services
• Published articles in local newspapers, real estate periodicals, online newsletters,
or other credible online sources
• Interviews with market participants (e.g., the parties to transactions, attorneys,
appraisers, counselors, brokers, property managers, lenders)
All raw data obtained from a general source (e.g., assessors’ records, data services)
will need further research and verification.
Appraisers should exercise caution when someone who is not a party to the
transaction provides sales data because the motivation of the parties to the transac-
tion is an important consideration. Sometimes brokers will be able to provide more
reliable information than the buyer or seller. Similarly, errors can result if anticipated
income and expense schedules are inaccurate or if potential changes in use that buy-
ers are planning are not considered.
A great deal of property and transaction information is available online and in
easily accessed public records, but experienced appraisers often maintain data files
with the details of important and unique market transactions and add information as
new transactions occur.
Verifying Transactional Data

Appraisers verify information with a party to the transaction to ensure its accuracy
and to gain insight into the motivation behind each transaction. The buyer’s and sell-
er’s views of precisely what was being purchased at the time of sale are important.
Sales that are not arm’s-length market transactions (in accordance with the definition
of market value used in the appraisal) should be identified and rarely, if ever, relied
on. As discussed in Chapter 9, to verify sales data appraisers can confirm statements
of fact with the principals to the transaction, if possible, or with the brokers, closing
agents, or lenders involved. Owners and tenants of neighboring properties may also
provide helpful information.
Sometimes income and expense data for income-producing properties is un-
obtainable. If data on a particular sale is unavailable, assigning rents and expenses
“based on market parameters” may not lead to credible results, especially for proper-
ties with existing leases.
Referencing public records and data services does not verify a sales transaction.
It simply confirms that a transaction was recorded. Similarly, referencing the source
of secondary data only confirms its existence and does not verify the transaction.
Generally, secondary sources do not provide adequate information about sale conces-

sions, whether the sale was an arm’s-length transaction, if multiple properties were
involved in the sale, if personal property was included, and other factors influencing
price. This underscores the importance of personal verification with persons knowl-
edgeable about the details of the transaction.
Selecting Units of Comparison

After sales data has been gathered and verified, systematic analysis begins. Like units
must be compared, so in many cases the sale price should be stated in terms of ap-
propriate units of comparison. The units of comparison selected depend primarily on
the nature of the property, as illustrated in Table 20.1.
Table 20.1 Typical Units of Comparison

Property Type Typical Units of Comparison
Apartment properties Price per apartment unit
Price per room or per bedroom
Price per square foot of gross building area
Price per finished square foot of building area
Price per net square foot of building area
Warehouses Price per cubic foot of gross building volume
Price per truck door
Factories Price per square foot of gross building area
Office properties Price per square foot of gross building area
Price per square foot of rentable area
Price per square foot of usable area
Hotels and motels Price per guest room
Restaurants, theaters, and auditoriums Price per seat
Price per square foot
Hospitals Price per square foot of gross building area
Price per bed
Golf courses Price per round (annual number of rounds played)
Price per membership
Price per hole
Tennis and racquetball facilities Price per playing court
Mobile home parks Price per parking pad
Marinas Price per slip
Price per linear foot
Automobile repair facilities Price per bay
Agricultural properties Price per acre
Price per tillable acre
Price per animal unit (for pastureland)
Price per board foot (for timberland)
Vacant land Price per front foot
Price per square foot
Price per FAR foot
Price per acre
Price per buildable square foot
Price per buildable unit
Water reserves Price per acre foot of water

Units of comparison are not applied to all property types, with single-unit resi-
dential properties being the most common example. While it is possible to calculate
a price per square foot of gross living area for a house, most residential appraisers do
not focus on that unit of comparison but instead base the analysis on the total price.
This is also true in markets where the participants do not think in terms of a unit of
comparison. The units of comparison applied to a given property type are not just
considered by appraisers. They will also be considered by the market participants
and by brokers and other real estate professionals.
Appraisers use units of comparison to facilitate comparison of the subject and
comparable properties. The sales should be analyzed to determine which units of
comparison indicate the least amount of variance when applied to the comparable
sales. This analysis will identify the proper unit of comparison to be used, such as
price per acre or price per square foot, which is especially important for properties
located in markets that are in transition.
As a simple example, suppose the subject of an appraisal is a 90,000-sq.-ft. dis-
tribution center with ten loading docks. The four properties shown below have been
sold in the last year:
Building Building Site Number
Area Area Area of Loading
Property Sale Price (Sq. Ft.) (Cu. Ft.) (Acres) Docks
125 W. Afton Road $8,500,000 100,000 2,200,000 5.00 10
Burberry Glen Commerce Center $10,200,000 150,000 3,000,000 6.80 12
6700 Northwest Highway $9,625,000 125,000 2,000,000 5.00 11
Northwest Crossing Business Center $8,600,000 86,000 2,150,000 4.30 10
Converting the sale prices to unit prices gives appraisers a better picture of what unit
of comparison the market is likely to use to compare these transactions:
Building Building Site Number
Area Area Area of Loading
Property Sale Price (Sq. Ft.) (Cu. Ft.) (Acres) Docks
125 W. Afton Road $8,500,000 $85.00 $3.86 $1,700,000 $850,000
Burberry Glen Commerce Center $10,200,000 $68.00 $3.40 $1,500,000 $850,000
6700 Northwest Highway $9,625,000 $77.00 $4.81 $1,925,000 $875,000
Northwest Crossing Business Center $8,600,000 $100.00 $4.00 $2,000,000 $860,000
In this example, the narrow range indicated for price per loading dock ($850,000-
$875,000) suggests that buyers and sellers in this market would be likely to analyze
competitive distribution centers based on their price per loading dock. Developing
the individual unit of comparison’s mean and standard deviation allows an appraiser
to identify a best unit of comparison for the data set, using its coefficient of variation.
Indicated Indicated Indicated
Property Mean Standard Deviation Coefficient of Variation
Sale price per square foot $82.50 $13.58 16.5%
Sale price per cubic foot $4.02 $0.59 14.6%
Sale price per acre $1,781,250 $226,729 12.7%
Sale price per dock $858,750 $11,815 1.4%

The coefficient of variation from the sample of sales suggests that the price per load-
ing dock is the most appropriate unit of comparison for the property in the market
being studied.3
If more comparable data were available, more statistical testing could be run on
each variable to analyze the variation among the unit prices. The variable with the
least variation would be a likely candidate for the best unit of comparison. Any final
decisions regarding units of comparison, however, should only be made after person-
al verification has confirmed that market participants use those units of comparison.
If personal verification is not possible, appraisers may want to review the marketing
materials for similar properties.
Sometimes the use of units of comparison can replicate another approach to value
and, in effect, tie the value indications together. For example, if an appraiser develops a
ratio of sale price to the net operating income (NOI) per square foot in the sales compari-
son approach, that analysis is now tied to the income approach. A value indication devel-
oped using net operating income per square foot (NOI per sq. ft.) as a unit of comparison
is not an independent indication of value but a restatement of the income approach.
Appraisers should consider why the income per unit varies among the sale prop-
erties. Sensitivity and trend analyses may be performed to gain an understanding of
this variance for use in the income capitalization approach. For example, appraisers
may analyze sales of income-producing properties to derive potential and effective
gross income multipliers, overall and equity capitalization rates, and even total antici-
pated property yield rates. These factors are not adjusted quantitatively except for any
necessary transactional adjustments when atypical financing or the transfer of certain
property rights affects a sale price. Instead, appraisers consider the range of multipliers
and rates and the similarities and differences between the subject and comparable sale
properties that cause the multipliers and rates to vary. They then conclude the most ap-
propriate rate indicated for the property being appraised based on its similarity to those
in the data sample.
Analyzing and Adjusting Comparable Sales

If all comparable properties are identical to the subject property, no adjustments to
sale prices will be required. However, this is rarely the case. After researching and
verifying transactional data and selecting the appropriate unit or units of comparison,
appraisers adjust for any differences that affect the sale prices of the comparables.
After sales information has been collected and confirmed, it can be organized in
a variety of ways. One convenient and commonly used method is to arrange the data
on a market data adjustment grid. Each important difference between the comparable
properties and the subject property that could affect property value is considered an ele-
ment of comparison. Each element of comparison that is found to affect sale prices in the
market is assigned a row on an adjustment grid, and total property prices or unit prices
of the comparable properties are adjusted to reflect the value impact of these differences.
The use of the grid is a way for appraisers to model typical buyer actions and to analyze
sales data to quantify the influence of certain characteristics on value. While not required
by valuation standards, when included in appraisal reports grids are a good way for
appraisers to communicate their logic clearly and efficiently to readers. The adjustment
3. This example is included to illustrate the application of statistical methods. The larger the sample size (in this case, the number of comparable
sales analyzed), the more meaningful the results of the statistical analysis would be.

grid shown in Table 20.3 only provides space for the calculations. Appraisal reports typi-
cally include narrative descriptions of how and why the adjustments were made.
Identification and Measurement of Adjustments

A sale price reflects many different elements that affect a property’s value in varying
degrees. Quantitative and qualitative techniques are employed to estimate the rela-
tive significance of these factors. Both are recognized and accepted techniques and
appropriate in certain circumstances.
Quantitative adjustments are developed as either dollar or percentage amounts.
What some practitioners call “qualitative adjustments” are not actually numerically
adjusted. The analysis of a qualitative difference simply provides an upward or
downward indication of the effect of the element. Examples of the techniques used
in quantitative adjustments and qualitative analyses are shown in Table 20.2 and are
discussed more fully in Chapter 21.
Adjustments can be made either to total property prices or to appropriate units of
comparison. Often the transactional adjustments—property rights conveyed, financ-
ing, conditions of sale (motivation), expenditures made immediately after purchase,
and market conditions (date of sale)—are made to the total sale price. The adjusted
price is then converted into a unit price and adjusted for property-related elements of
comparison such as physical and legal characteristics.
Table 20.2 Techniques Used in Quantitative and Qualitative Analysis

Quantitative Analysis Qualitative Analysis
• Paired data analysis (sales and resales of the same or similar properties) • Relative comparison analysis
• Grouped data analysis • Ranking analysis
• Secondary data analysis • Personal interviews
• Statistical analysis including graphic analysis and scenario analysis
• Cost-related adjustments (cost to cure, depreciated cost)
• Capitalization of income differences
• Trend analysis
Elements of Comparison
Elements of comparison are the characteristics of properties and transactions
that help explain the variances in the prices paid for real property. An appraiser
determines the elements of comparison for a given appraisal assignment through
market research and supports those conclusions with market evidence. When
properly identified, the elements of comparison describe the factors that are
associated with the prices paid for competing properties. The market data, if
analyzed properly, will identify the elements of comparison within the comparable
sales that are market-sensitive.
The basic elements of comparison that should be considered in sales comparison
analysis are as follows:
• Real property rights conveyed (e.g., fee simple estate, leased fee, leasehold)
• Financing terms (e.g., all cash, market financing, seller financing, special or atypi-
cal terms)

Table 20.3 Sample Adjustment Grid: Comparison and Adjustment of Market Data
Element Subject Sale 1 Sale 2 Sale 3 Sale 4
Sale price unknown
Transactional Adjustments
Real property rights conveyed adjustment
Adjusted price*
Financing adjustment
Adjusted price†
Conditions of sale adjustment
Adjusted price‡
Expenditures made immediately after purchase
Adjusted price§
Market conditions adjustment
Adjusted price**
Property Adjustments

Subtotal
Final adjusted sale price
For reconciliation purposes:
Net adjustment††
Net adjustment as % of sale price
Gross adjustment††
Gross adjustment as % of sale price
* Sale price adjusted for property rights conveyed
† Sale price further adjusted for financing
‡ Sale price further adjusted for conditions of sale
§ Sale price further adjusted for expenditures made immediately after purchase
** Sale price further adjusted for market conditions
†† Net and gross adjustments include all transactional and property adjustments
• Conditions of sale (e.g., short sale, bank-owned real estate [REO], private estate,
relocation, 1031 tax-free exchange, or other atypical motivations)
• Expenditures made immediately after purchase (e.g., new roof, renovation costs)
• Market conditions (e.g., changes in supply and demand or other causes of price
changes)
• Location (e.g., neighborhood, interior lot, waterfront, arterial street)
• Physical characteristics (e.g., size, shape, soils, access, construction quality, condition)
• Economic characteristics (e.g., expense ratios, lease provisions, management,
tenant mix)
• Legal characteristics (e.g., zoning/use requirements, environmental regulations,
building codes, flood zones, differences in highest and best use)

• Non-realty components of value (e.g., personal property, furniture, trade fixtures,
and equipment [FF&E], franchises, trademarks)
Other possible elements of comparison include governmental restrictions and off-site
improvements required for the development of a vacant site. The differences in some
of these elements of comparison can be so large or so significant that the property is
no longer comparable.
Often a basic element of comparison is broken down into subcategories that spe-
cifically address the property factor being analyzed. For example, physical character-
istics may be broken down into subcategories for age, condition, size, and so on. (Ad-
justment techniques for each of the standard elements of comparison are illustrated
in Chapter 21.) There is no limit to the number of elements of comparison that may
be found in a market, so it is important to remember that another line can always be
added to an adjustment grid for an additional item recognized in the market. For ex-
ample, appraisers may need to add “deck” as an element of comparison if the market
makes distinctions in sale price based on the presence or absence of a deck. However,
note that adding elements of comparison for adjustment may lead to multiple adjust-
ments for the same factor, an error that is discussed in Chapter 21.
The sample adjustment shown in Table 20.3 reflects the initial elements of
comparison in a typical sequence. Blank lines are provided for additional property-
related adjustments. The first five adjustments (for real property rights conveyed,
financing terms, conditions of sale, expenditures made immediately after purchase,
and market conditions) are considered transactional adjustments. The last five (for
location, physical characteristics, economic characteristics, legal characteristics, and
non-realty components) are considered property adjustments. If the comparable
properties are similar to the subject property in regard to a specific element of com-
parison, no adjustment is required for that element. The sample grid includes sepa-
rate lines for each element of comparison and adjustment to ensure that adjustments
are made in a consistent manner. It is important to make adjustments only for those
factors that materially influence the decision-making process of market participants.
In addition, appraisers should exercise care to ensure that adjustments are not being
made twice for the same factor and that all material influences have been considered.
Actual adjustment grids will vary depending on the nature and type of property
and the units and elements of comparison used by market participants. Adjustments
may be made in terms of percentage or dollar amounts.
The section labeled “For reconciliation purposes” is provided to help the apprais-
er analyze the comparability of each sale, which indicates the relative reliability of
the separate value indications derived. The final adjusted sale price of each transac-
tion is a potential value indication for the subject property. Together the adjusted sale
prices of the comparable properties suggest a range of values within which the value
of the subject property should fall. Each adjusted sale price can be analyzed to show
the total, or absolute, adjustment made to the sale price of the comparable property
and the percentage or dollar amount of the sale price that is reflected by this total
adjustment. With these value estimates, the appraiser can rank the comparability
of the sales to the subject and select an appropriate opinion of value, assuming the
value conclusion is to be reported as a point estimate. The sale that requires the least
significant or lowest total adjustment (i.e., the absolute adjustment based on the sum
of the adjustments regardless of sign) is often the most comparable and is frequently

given the most weight in reconciling the value indications from the sales comparison
approach. Simply averaging the results of the adjustment process to develop an aver-
aged value fails to recognize the relative comparability of the individual transactions
as indicated by the size of the total adjustments and the reliability of the data and
methods used to support the adjustments. Final conclusions are always contingent
on the quality and availability of data.
Sequence of Adjustments
The sequence in which adjustments are applied to the comparable sales is deter-
mined by the market data and an appraiser’s analysis of that data. As mentioned
earlier, the first five elements of comparison in the list are considered transactional
adjustments, while the latter five (and any additional items) are considered property
adjustments (see Figure 20.1). The transactional adjustments are generally applied in
the order listed. The property adjustments are usually applied after the transactional
adjustments, but in no particular order. The categories of property adjustments—lo-
cation, physical characteristics, economic characteristics, legal characteristics (use),
and non-realty components—correspond to the criteria of highest and best use:
• Physical possibility—location and physical characteristics
• Legal permissibility—legal characteristics such as zoning
• Financial feasibility—economic characteristics and non-realty components that
influence the value of the real property
Figure 20.1 Transactional and Property Adjustments

1. Real property rights conveyed
2. Financing terms
3. Conditions of sale Transactional adjustments
4. Expenditures made immediately after purchase
5. Market conditions
6. Location
7. Physical characteristics
8. Economic characteristics Property adjustments
9. Legal characteristics
10. Non-realty components of value
The sequence of adjustments presented in Table 20.4 is provided for purposes of

illustration only. The sequence of adjustments shown in Figure 20.1 is not the only
order in which quantitative adjustments can be made. Adjustments may be applied
in other sequences if the market and the appraiser’s analysis of the data so indicate.
Using the adjustment sequence, appraisers apply successive adjustments to the prices
of comparable properties.
Most property types are adjusted on a unit price basis. Property adjustments for
location, physical characteristics, economic characteristics, legal characteristics (use),
and non-realty components are typically applied to a unit price.

Table 20.4 Sequence of Adjustments
Market-Derived Adjustment Applied to Sale Price
Adjustment of Comparable Property
Sale price of comparable property* $400,000
Element of Comparison
Transactional adjustments
Adjustment for property rights conveyed + 5% + 20,000
Adjusted price $420,000
Adjustment for financing terms - 2% - 8,400
Adjustment for conditions of sale† + 5% + 20,580
Adjustment for expenditures immediately
after purchase + $20,000 + $20,000
Adjustment for market conditions + 5% + 22,609
Property adjustments
Adjustment for
Location + 14,250
Physical characteristics - 23,750
Economic characteristics - 24,000
Legal characteristics + 9,500
Non-realty components - 12,000
Indication of value $438,789
* In the market data grid, the sale price could be converted into a unit price, such as price per square foot of leasable area, and adjustments
made to the unit price rather than the sale price.
† Although in this case the adjustment for conditions of sale is independent of the adjustment for financing terms, sometimes the adjustment
amount for financing terms can reflect some of the influence of a difference in conditions of sale. Chapter 19 includes discussion of how to
avoid double-counting for the effect of these two elements of comparison.
Reconciling Value Indications in the Sales Comparison Approach

Reconciliation is the process that converts an estimate into an opinion or conclusion
and is necessary in nearly all applications of the sales comparison approach because
the adjusted sales prices usually provide various value indications.4 These value
indications are resolved into a range of value or a single value indication (i.e., a point
estimate). It is important that appraisers consider the strengths and weaknesses of
each comparable sale, examining the reliability and appropriateness of the market
data compiled and the analytical techniques applied in the comparative analysis. The
appraisal report should clearly communicate how the appraiser arrived at the value
indication using the sales comparison approach:
• What does the data show and how did the appraiser come to the value conclusion?
• What data was good, bad, missing?
• How and why did the appraiser come to the conclusion made in the sales com-
parison approach?
4. In addition to reconciliation within the sales comparison approach, reconciliation is also required when value indications are derived using two
or more approaches to value. At that point in the valuation process, reconciliation results in the opinion of value identified in the definition of the
appraisal problem. Reconciliation of the final opinion of value is discussed in Chapter 32.

In reconciling value indications in the sales comparison approach, appraisers
evaluate the number and magnitude of adjustments and the importance of the indi-
vidual elements of comparison in the market to judge the relative weight a particular
comparable sale should have in the comparative analysis. For example, location is the
most important element of comparison for some properties and other factors are of
lesser importance. For such a property, comparable sales that require less adjustment
for differences in location are likely to be given more weight in the reconciliation.
The gross adjustment percentage is the percentage of total adjustments (absolute
values) divided by the sale price. This means a $10,000 upward adjustment and a
$10,000 downward adjustment on a $100,000 sale would be $20,000 / $100,000 = 20%.
The net adjustment percentage is the percentage of adjustment to the sales based
on the total net adjustment divided by the sale price. This means a $100,000 sale with
$10,000 upward adjustment and $5,000 downward adjustment would have a net
adjustment percentage of $5,000 / $100,000 or 5.0%. Both percentages are recognized by
users of appraisal services as indications of the comparability of the sales to the subject.
If a comparable transaction requires fewer adjustments than the other comparable
transactions and the magnitude of the adjustments is approximately the same, apprais-
ers may give more weight to the value indications obtained from the transaction with
the fewest adjustments. Similarly, the gross adjustment amount can be a significant
factor in the reconciliation of various value indications. Even though the number of ad-
justments made to the sale prices of the comparable properties may be similar, the total
gross adjustment as a percentage of each respective sale price might vary considerably.
For example, suppose an appraiser analyzes five comparable properties, each of which
require several adjustments. However, the gross dollar amount of adjustments for one
comparable property totals 15% of the sale price, while the gross dollar adjustment for
each of the other four properties is less than 5% of the sale price. If the sales are similar
otherwise, less accuracy may be attributable to the comparable property that required
the larger adjustment as a percentage of the sale price.
The size of a gross adjustment percentage may indicate the possibility of an error
in the analysis, but more likely it is due to the variances in buyer behavior or the dis-
Reconciliation Checklist
In the reconciliation process, appraisers often ask questions about the data and techniques used in the
sales comparison approach including, but not limited to, the following:
• Is the comparable property similar in terms of physical characteristics and location?
• Does the comparable property have the same highest and best use?
• Was this property developed, rented, or sold in the same market as the subject property?
• Are the characteristics of the transaction similar to those expected for the subject property?
• Would a potential buyer of the subject property consider the comparable property as a reasonable alterna-
tive to the subject?
• Is one method preferred over another given the data available for each analysis?
In some cases, appraisers may ask additional questions:
• Are the expenses of the comparable properties appropriate indicators of the expenses of the appraised
property?
• Are the estimates of depreciation in the subject improvements justified?

similarity of the comparable sales presented. Care should be exercised not to dismiss
a gross adjustment entirely just because of its size. A comparable with a large gross
adjustment may be given weight when all other items of adjustment for the other
comparable properties have been given consideration and the item(s) leading to the
large gross adjustment has greater reliability. For example, a $1,000,000 property
sale may have required only a $150,000 adjustment for expenditures immediately
after purchase made to reflect the buyer’s recognition of deferred maintenance in the
building’s roofing, HVAC, and other items. Although this represents a 15% adjust-
ment, the amount of adjustment might be considered well-reasoned and supported
and given greater consideration over other adjustments that are smaller.
The net adjustment is calculated by totaling the positive and negative adjust-
ments and this adjustment figure may be misleading. For example, if a comparable
property is adjusted downward by 20% for one element of comparison and upward
by 20% for another element of comparison, the net adjustment is 0% but the gross
adjustment is 40%. Another comparable sale may require several adjustments, all
positive or all negative, resulting in a gross and net adjustment of 30%. This property
may well be a more accurate indicator of the subject’s value than the comparable sale
with the 0% net adjustment, which had large positive and negative adjustments that
cancel each other out mathematically.
It is also good practice in the reconciliation process to reexamine the major ele-
ments of comparison for which no adjustments were made and to explain why these
elements of comparison did not require any adjustments.
Even when adjustments are supported by comparable data, the adjustment pro-
cess and the indicated values should reflect good judgment. Small inaccuracies can
be compounded when several adjustments are added or multiplied, and thus seem-
ingly precise arithmetic conclusions derived from adjusted data might contradict the
appraiser’s judgment. The sales comparison approach is not formulaic. It does not
lend itself to detailed mathematical precision. Rather, it is based on judgment and
experience as much as quantitative analysis.
Units of Comparison and Real Property Interests in the Reconciliation Process

Two related points should be stressed in any discussion of the reconciliation process. In
arriving at a final value indication in the sales comparison approach, appraisers must
ensure that the value concluded is consistent with the value indications derived from
the other approaches to value. This is especially important in regard to the date of an
opinion of market value. For example, an appraiser may seek an opinion of the market
value of a proposed income-producing property at two different points in the future—
e.g., when the project is completed and when occupancy reaches a point of stabilization.
The only market data available, however, may pertain to comparable properties at or
near stabilized occupancy. Typically, this data is appropriate only for an analysis of the
market value of the subject property at the point of stabilized occupancy. As a result,
the appraiser will need to reconcile the market value indication based on this data with
value indications derived from the other approaches for the corresponding date of sta-
bilized occupancy. In these cases, care must be exercised in the reconciliation process.
Appraisers must also consider any differences in the property rights appraised
between the comparable properties and the subject property because the comparable
sales may include the transfer of a leased fee. If the data is not properly analyzed in
the sales comparison approach, the value indication concluded for the leased fee of

the subject property upon the achievement of stabilized occupancy might be lower
or higher than the value for the fee simple estate. This value indication would not be
compatible with the corresponding value indications derived from the cost and income
capitalization approaches for the fee simple estate of the subject property unless ad-
justments have been made. Failure to recognize that the value indications may apply
to different property rights would likely result in an inaccurate value conclusion.

Comparative Analysis 21
Comparative analysis is the general term used to identify the process in the sales
comparison approach in which quantitative and qualitative techniques are applied to
comparable sales data to derive a value indication.1 Appraisers may use both quanti-
tative adjustments and qualitative analysis in comparative analysis.
The process of researching and applying adjustments involves a thorough
analysis of the comparable sales to identify the elements of comparison that affect the
value of the type of property being appraised. Quantitative adjustments derived in
comparative analysis and applied to the sale prices of the comparable properties may
be expressed in numerical amounts (e.g., dollars, percentages). The conclusions of
qualitative analysis may be described in terms that clearly convey the relative differ-
ence between the comparable property and the subject property in regard to each ele-
ment of comparison (e.g., inferior, superior, similar). When quantitative differences
cannot be identified for a specific element of comparison, qualitative analysis is used
to determine which comparable sales are inferior, similar, or superior to the sub-
ject property for that element of comparison. In applying quantitative adjustments,
qualitative analysis, or both, appraisers must ensure that their reasoning is clear and
adequately explained in the appraisal report. The extent of narrative explanation
required also depends on the complexity of the property being appraised. The more
complex the property, the more factors that must be considered in the analysis and
then explained to intended users of the appraisal.
Quantitative Adjustments
Several techniques are available to quantify adjustments to the sale prices of compa-
rable properties:
• Data analysis techniques such as paired data analysis, grouped data analysis, and
secondary data analysis
1. Market rent can also be developed using comparative analysis.

• Statistical analysis, including graphic analysis and scenario analysis
• Cost-related adjustments (cost to cure, depreciated cost)
• Capitalization of income differences
Appraisers can usually find some logic to support most quantitative adjust-
ments given the number of tools available to them. Of course, the value indication
supported by quantitative adjustments may differ from the results of cost or income
capitalization analysis, and appraisers will have to reconcile the results of the sales
adjustment process with the results of the other approaches to value in the final
reconciliation. Above all, mathematical adjustments should reflect the reactions of
market participants.
Data Analysis Techniques

Paired data analysis is based on the premise that when two properties are equivalent
in all respects but one, the value of the single difference can be measured by the dif-
ference in price between the two properties. For example, two residential properties
are similar in all respects except for location—one property has a corner lot while the
other is on an interior lot. If both properties sell at a similar time so that there is no
difference in market conditions, the difference in sale price can be attributed to the
different locations of the properties, and that identifiable difference can be used in
the adjustment process. If the home on the corner lot sold for $30,000 more than the
home on the interior lot, that difference, either as a dollar amount or a percentage,
could be used to adjust the sale prices of other comparable sales in the market for
location on a corner lot or an interior lot.
Paired data analysis should be developed with extreme care to ensure that the
properties are truly comparable and that other differences do not exist. Using only
one such pairing to draw conclusions can lead to a false impression, since there may
be significant factors unknown to the researcher that may impact the value. This is
why appraisers try to use several paired sales to support the adjustments and pre-
vent an unknown factor from contributing to a misleading conclusion.
A related technique, grouped data analysis, involves grouping data by an inde-
pendent variable such as date of sale and calculating equivalent typical values. The
grouped sales are studied in pairs to identify the effect on a dependent variable such
as the unit price of comparable properties. To apply this technique to the market used
in the example described above, an appraiser would compare a group of comparable
homes all on interior lots to a different group of residences all on corner lots, rather
than comparing just one property of each type. The sales would be used to develop a
range and then reconcile the value indications.
These techniques can be time-consuming and sometimes difficult to apply with a
high level of mathematic precision. Nevertheless, they can be useful analytical tools
if their weaknesses are appropriately recognized and they are applied in combination
with other methods.
Paired data and grouped data analysis are variants of sensitivity analysis, which
is a method used to isolate the effect of individual variables on value. Often associ-
ated with risk analysis, sensitivity analysis studies the effect of variables on different
measures of return.
Although paired data analysis of sales or rents is a theoretically sound method, it
may be impractical and could produce unreliable results when only a narrow sam-

pling of sufficiently similar properties is available. This is particularly true for com-
mercial and industrial properties and properties that do not sell or lease frequently in
a market. A lack of data can make quantifying the adjustments attributable to all the
variables a difficult process. An adjustment derived from a single pair of sales is not
necessarily indicative, just as a single sale does not necessarily reflect market value.
Special care must be taken when relying on pairs of adjusted prices because the
difference measured may not represent the actual difference in value attributable
to the characteristic being studied. The difference may include other aspects of the
property, not just the one characteristic being studied. Pure pairings may be analyzed
first. For example, data on a sale and resale of the same property may be compared
to derive a market conditions adjustment. Pairings of adjusted sales should only be
used as an analytical tool when truly pure pairings are unavailable. When more than
one element of comparison is involved, additional pairs can be studied to isolate
and extract the differing elements of comparison. However, in these cases care must
be exercised to ensure that the process accurately reflects differences considered by
market participants.
Comparable properties that contain different unit or inventory mixes—e.g., apart-
ment buildings with one-, two-, and three-bedroom units or agricultural lands with
different types of soil—should be adjusted for that difference before pairing analysis
is conducted. A unit or inventory mix adjustment is required to ensure that pairings
of comparable properties and the subject property are made on the same basis. An
appraiser may be able to extract this adjustment through an investigation of the value
relationships among the different classes of properties within the same property type.
Grouped data analysis extends the logic of paired data analysis to larger data
sets. In this technique, comparable sales are grouped by an independent variable
such as date of sale and then the groups are studied as pairs. For example, sales of
units in an industrial park that occurred in 2018 are grouped together, and the mean
sale price for that year is compared to the mean sale price of another group of sales
that occurred in 2019. Analyzing the pairs of mean sale
prices gives a measure of the change in sale prices from
2018 to 2019. Examples of applications of
Another form of data analysis—secondary data paired data analysis in this
analysis—is used to support adjustments derived by chapter include
other methods. This technique makes use of data that • The comparison of sales
and resales of homes
does not directly pertain to the subject or comparable to determine a market
properties. This secondary data describes the general conditions adjustment
real estate market and is usually collected by a data • The analysis of incremen-
vendor research firm or government agency like the tal rent in Table 21.4
county assessor. Secondary data may need verification.
Statistical Analysis
Statistical methods may also be applied to calculate adjustments to comparable sales.
To use any form of statistical analysis, an appraiser must understand (and properly
apply) fundamental statistical concepts as well as the particular methodology selected.2
2. Full discussion of the statistical methods applicable to the sales comparison approach is beyond the scope of this text. Chapter 14 provides a review
of basic statistical concepts and applications. In addition, The Appraisal Journal, Journal of Property Tax Assessment & Administration, The Journal
of Real Estate Research, Real Estate Economics, and other scholarly journals have published many articles on advanced statistical applications.

In applying statistical analysis, an appraiser must be careful not to develop a result that
is mathematically precise yet logically meaningless or inappropriate for the particular
appraisal. As with other adjustment techniques, statistical analysis must reflect the
thought processes and conclusions of market participants to serve as a useful, persua-
sive valuation tool.
In one common application, appraisers can develop a series of adjustment
factors to control for different tract sizes by creating a simple linear regression
model and then use the results of the regression analysis as a means of inferring the
size adjustment for properties within the range of the data. If a reasonable pattern
emerges, the model can be applied to a group of sales with differing land sizes to
test its accuracy, although the process might also demonstrate that the indicated
adjustments are incorrect.
Appraisers should recognize the differences between statistical processes in the
collection and description of data and should be able to distinguish between descrip-
tive and inferential statistics. Without an understanding of these basic issues, any use
of statistical calculations is dangerous or ill-advised.
Scenario analysis is a form of modeling in which the conditions created by future
events are forecast to test the probability or correlation of alternative outcomes. In the
adjustment process, alternative scenarios can be created and then modeled to test the
influence of changes in various elements of comparison on sale price. The technique
allows appraisers to forecast best, most-likely, and worst-case scenarios (such as the
potential performance of proposed improvements) or to create other scenarios testing
a range of values rather than a single point estimate. Scenario analysis is often used
to measure the risk associated with certain market events and investment decisions.
Graphic Analysis
Examples of applications A simple graphic display of grouped data may il-
of graphic analysis in this lustrate how the market reacts to variations in the
chapter include
elements of comparison or may reveal submarket
• The analysis of a sale price
trend shown in Figure 21.1
trends. In curve fit analysis, different formulas may
• The comparison of prop-
be employed to determine the best fit for the market
erty locations shown in data being analyzed. The most reliable equation for the
Figure 21.3 best-fitting curve can be plotted, or the most appropri-
ate equation of those commonly used to solve for an
adjustment can be identified.
Trend Analysis
Trend analysis is applicable when a large amount of market data is available. Such
analyses are often useful in a variety of applications. They are especially useful when
there is a limited number of closely comparable sales but a large number of proper-
ties with less similar characteristics. The various elements of comparison influencing
a sale price can be tested to determine their market sensitivity. Once appraisers have
determined which elements of comparison show market sensitivity, price patterns
can be analyzed to support other analyses.
In the application of market analysis, the term trend analysis refers specifically
to inferred demand analysis, i.e., using historical data and statistics to draw infer-
ences about the future, assuming that a property or property type will perform in the

future as it has in the past. In the context of statistical
An example of the application
theory, trend analysis is often defined as analysis of a
of cost analysis in this chapter
time series. In the context of sales comparison, the term is the adjustment for expendi-
simply refers to the use of statistical techniques to make tures made immediately after
comparisons of variables other than time. purchase in the valuation of
an industrial building.
Cost Analysis and Cost-related Adjustments
In cost analysis, adjustments are based on cost indicators
such as depreciated building cost, cost to cure, or permit
fees. Cost-related adjustments are most often used in markets with limited sales activity
or for properties where isolating a feature is difficult to do, e.g., a porch on a residential
property or a grain bin on an agricultural property that has 12 other outbuildings.
Buyers are clearly conscious of the cost of repairs, additions, or conversions, as
can be seen in the application of the cost approach (Chapters 29, 30, and 31). How-
ever, the cost of an improvement does not always result in an equal increase in value
for the property as a whole. For example, adding a swimming pool to a residential
property at a cost of $50,000 may only add $25,000 to the value of the property in one
market, but it may add value commensurate with the pool’s physically depreciated
cost in a market where that recreational amenity is expected or demanded by buy-
ers. As another example, a potential buyer of a refrigerated warehouse may also look
at buildings without refrigeration that can be converted into refrigerated space and
factor into an offer the cost of conversion (as well as other cost considerations such as
the time the building would be unavailable for use during the conversion).
Capitalization of Income Differences

Differences in net operating income can be capitalized to derive an adjustment when
the income loss or gain incurred by a comparable property reflects a specific deficien-
cy or benefit to the property. Examples of scenarios in which an income loss could be
capitalized to derive an adjustment to account for a deficiency would include the lack
of an elevator in a low-rise office building and inadequate parking for a convenience
store. In contrast, a comparable property may enjoy a competitive advantage over
the subject property, in which case the adjustment to the sale price of the comparable
property would reflect the income premium the property enjoys. For example, an in-
vestor may decide to purchase a building with an elevator or one without an elevator
based on the difference in potential rental rates.
Deriving an adjustment by capitalizing differences in
net income is a useful technique, but it can diminish the Examples of applications of
independence of the sales comparison and income capi- capitalization of income differ-
talization approaches. In theory, the approaches to value ences in this chapter include
are independent. In practice, the integration of the sales • The adjustment for real
comparison, cost, and income capitalization approaches property rights conveyed
in the sale of an office
may offer the best support for a value conclusion.
building
However, too much integration can negatively affect the
• The adjustment for
independence of the approaches and introduces the risk income loss due to the
of double-counting (as discussed later in the chapter). physical characteristics of
Capitalization of income differences is easier to sup- an apartment building
port than many other methods of quantifying adjustment

amounts, and the technique is recognized by investors as a valid method of comparison.
Sufficient data must be available and carefully verified. It is commonly used in eminent
domain assignments to illustrate a loss in value, e.g., the difference between the rental
income a property generates before and after an event such as a government taking of a
portion of the property. Capitalization of rent differences can also be used in the valua-
tion of residential property through the application of a gross rent multiplier if there is
adequate information on rents and rent differences.
Qualitative Analysis
Qualitative analysis recognizes the inefficiencies of real estate markets and the diffi-
culty of expressing adjustments with mathematical precision. It is essential, therefore,
that appraisers explain the analytical process and logic applied in reconciling value
indications using qualitative analysis techniques such as
• Relative comparison analysis
• Ranking analysis
• Personal interviews
Statistical analysis and graphic analysis may serve as qualitative techniques
when the results of those analyses do not support a precise adjustment amount but
do support qualitative conclusions about value trends. Graphical analysis is used in
cases when less data is available. Likewise, when trend analysis yields enough evi-
dence to support a precise adjustment amount, the technique could be considered a
quantitative adjustment technique. The nature of the data analyzed with the various
statistical techniques will dictate how the results of the analysis can be used, either as
an adjustment or as a qualitative indicator.
Relative Comparison Analysis

Relative comparison analysis is the study of the relationships indicated by market
data without recourse to quantification, i.e., the data reveals an ordinal relation-
ship between elements of a data set. Many appraisers use this technique because it
reflects the imperfect nature of real estate markets. To apply the technique, appraisers
analyze comparable sales and identify whether the characteristics of the comparable
properties are inferior, superior, or similar to those of the subject property.
Reliable results can usually be obtained by bracketing the subject property
between comparable properties that are superior and inferior to it. It is improper to
select comparable properties based solely on price. A
proper bracketing technique is typically based on prop-
Examples of applications of erty features (such as size) rather than price. It is un-
relative comparison analysis realistic to expect that the value indication will always
in this chapter include be supported by at least one sale at a price above and
• The comparison of ranges one at a price below. For example, if the comparable
of lot sizes shown in Table properties are either all superior or all inferior, only an
21.3
upper or lower limit of values is set and no range (or
• The analysis of vary-
ing maximum buildable bracket) of possible values for the subject property can
areas for office properties be defined. If all the comparable properties are inferior
shown in Table 21.6 in terms of qualitative factors, the only conclusion that
can be drawn is that the value of the subject property

is higher than the highest value indication from the
comparable properties. An example of the applica-
tion of ranking analysis in
Qualitative factors are the primary focus of brack- this chapter is the analysis
eting. If the available comparable sales do not bracket of corner and interior lot lo-
the subject property’s value, appraisers should con- cations shown in Table 21.1.
sider employing other analytical techniques to establish
a bracket. Quantitative adjustments to the comparable
sales can often serve this purpose.
Personal Interviews
Ranking Analysis Personal interviews are an
Ranking analysis is used to sort the comparable data for important part of the founda-
tion of the adjustment pro-
differences in specific elements of comparison, e.g., size, cess. That is, they can reveal
corner or interior lot, or frontage. The technique can be the opinions of knowledge-
used to test the specific elements of comparison for their able individuals participating
market sensitivities. The comparable sales are ranked ac- in the subject’s market such
cording to overall comparability or by some other element as trends in sale prices,
rents, or capitalization rates.
of comparison so that the relative position of each com- Although data gathered
parable sale to the subject property is clear. Specific value through personal interviews
trends can thereby be established for elements of com- is primary data, the opinions
parison that are market-sensitive, and those that show no of market participants (how-
discernible or reasonable trends will be discarded. ever valuable) should not be
used as the sole criterion for
estimating adjustments or
Elements of Comparison reconciling value ranges if an
alternative method that relies
As indicated in Chapter 20, elements of comparison on direct evidence of market
are the characteristics of properties and transactions transactions can be applied.
that help explain the variances in the prices paid for
real property. Basic elements of comparison usually
include the following:
• Real property rights conveyed
• Financing terms
• Conditions of sale
• Expenditures made immediately after purchase
• Market conditions
• Location
• Physical characteristics
• Economic characteristics
• Legal characteristics (use)
• Non-realty components of value
Each of the basic elements of comparison should be analyzed to determine
whether an adjustment is required. If sufficient information is available, a quantita-
tive adjustment may be made. If there is insufficient support for a quantitative adjust-
ment, the element of comparison may be better addressed using qualitative analysis.
Adjustments for differences in the elements of comparison are made to the price of
each comparable property. Adjustments may be made to the total property price, to a
common unit price, or to a mix of both, but the unit prices used must be applied con-

sistently to the comparable properties at the appropriate points in the adjustment pro-
cess. The magnitude of the adjustment made for each element of comparison depends
on how much that characteristic of the comparable property differs from the subject
property. The adjustment amount is based on the contribution to value difference.
Appraisers should consider all appropriate elements of comparison and avoid
double-counting adjustments for the same difference reflected in multiple elements of
comparison. This requires an awareness of situations in which the influence of differenc-
es in one element of comparison may have an effect on an adjustment derived for a dif-
ferent element of comparison. (This relationship, called multicollinearity, was discussed
in Chapter 14.) For example, an adjustment made to the sale of a comparable residential
property for the number of bedrooms in the house might be related to or be duplicative
of an adjustment that has already been made for the size of the house. The size difference
may be reflected in both elements of comparison—a classic multicollinearity problem.
Transactional Adjustments
The transactional adjustments are generally applied in a specific sequence:
1. Real property rights conveyed
2. Financing terms
3. Conditions of sale
4. Expenditures made immediately after purchase
5. Market conditions
Mathematical operations of multiplication and addition are commutative. This
means if the adjustments are based in either multiplication or addition, the order
does not matter unless some are multiplied and others are added. The reason to put
the transactional adjustments in a particular order is to allow extraction of capitaliza-
tion rates at a certain level. In most cases, the real property rights conveyed, financing
terms, conditions of sale, and expenditures made immediately after sale adjustments
are made before extracting the capitalization rate. However, the market conditions
adjustment is not made before extracting the capitalization rate because the income
and price should both be as of the date of sale.
Real Property Rights Conveyed

When real property rights are sold, they may be the sole subject of a contract, or the
contract may include other rights, less than all of the real property rights, or even
rights to another property or properties. Before a comparable sale property can be
used in sales comparison analysis, an appraiser must first ensure that the sale price
of the comparable property applies to property rights that are similar to those being
appraised. This may require one or more adjustments to the price of the comparable
property before specific differences in the physical real estate can be compared. And,
in some cases, it may eliminate the use of that sale as a possible comparable altogether.
For example, the rights conveyed by a quitclaim deed for real property may or
may not include the complete bundle of rights that make up the fee simple estate.3 If
a comparable sale involves a quitclaim deed, appraisers must determine if the buyer
and seller considered the transaction to be equivalent to a fee simple transaction or
3. A quitclaim deed is a method of conveying title to real property in which any interest the grantor possesses in the property described in the deed
is conveyed to the grantee without warranty of title.

must seek other supporting evidence before using the transaction for the appraisal of
the fee simple estate in the subject property. It is possible that the transaction cannot
be used for direct comparison purposes at all because there is such a limited amount
of data to support an adjustment for the difference in rights or the quitclaim deed
may be for purposes of clearing the title.
Some sale contracts call for the sale of real property rights but add deed restric-
tions or other forms of limitation on the purchaser or on future users of the property.
That sort of title or use limitation, which causes the real property rights conveyed to be
less than fee simple, must be addressed in the analysis. If it is not possible to analyze
its effect on value, the transaction may be less useful for direct market comparison.
Income-producing real estate is often subject to an existing lease or leases en-
cumbering the title. Leases may either increase or decrease the market value of the
full bundle of rights, depending on how the contract rent rates and terms compare
with market rent and terms. If the sale of a leased property (i.e., the leased fee) is to
be used as a comparable sale in the valuation of another interest in real property, the
comparable sale can only be used if reasonable and supportable market adjustments
for the differences in real property rights can be made. For example, consider the
appraisal of the fee simple estate in a property that is improved with a multitenant
office building. A similar improved property was fully leased at the time of sale, the
leases were long-term, and the credit ratings of the tenants were good. To compare
the value of the leased fee of the comparable property to the value of the fee simple
estate of the subject property, an appraiser must determine if the contract rent of the
comparable property was above, below, or equal to market rent. The appraiser must
also determine whether contract rent represents income attributable to increases in
rent under existing leases resulting from stated escalations in the leases or tenant re-
imbursement of expenses. If the market rent for office space is $25 per square foot net
and the average contract rent for the comparable property is $20 per square foot net,
then the difference between market and contract rent is $5 per square foot.
Calculating an adjustment for differences in real property rights is also necessary
when the subject property involves the fee simple and the comparable sale involves
the leasehold or vice versa. Although it is usually not recommended that the sale of a
leasehold be compared with a fee simple or leased fee, the limited availability of sales
of directly comparable interests may make this necessary. Careful analysis of the leases
of the subject property and comparable properties is required.
The prices that buyers and sellers negotiate can be affected by many factors
related to the income projections for a subject property and comparable properties.
For example, suppose a land owner leases a commercial site to a fast food restaurant
company for $5,000 per month ($60,000 per year) for 40 years. The restaurant com-
pany builds a building with a cost of $2 million on the leased land. If the capitaliza-
tion rate for the leased fee is 5.0%, the market value of the leased fee would be $1.2
million ($60,000/0.05). Now suppose that the same property had been leased for only
$2,000 per month ($24,000). In that case, the market value of the leased fee would be
$480,000 ($24,000/0.05).4 That amount is the market value of the leased fee interest,
not the fee simple land value, which cannot be either $1.2 million or $480,000.
In a comparison of properties that are encumbered by long-term leases or are
essentially fully leased with quality tenants, appraisers must recognize that these
4. A different capitalization rate may be appropriate when the rent is below market.

leased properties may have significantly less risk than a competitive property that
has shorter-term tenants at market rental rates. On the other hand, the reverse may be
true in expanding markets. The ability to demand higher rental rates and the ready
availability of tenants may favor the shorter-term lease strategy. The market position
of a fully leased building is clearly different from that of a building with no leases at
all. The buyer of a multitenant property that has a good cash flow in place may not
be the same buyer who is interested in a property that is only one-third occupied. In
the case of the property with two-thirds vacancy, the buyer may need a higher down
payment and another portion of the purchase price to cover the shortfalls created by
the lease-up period. It is quite common for buyers of nearly empty buildings to have
to invest capital for many years until the properties reach stabilized occupancy. The
period over which the property leases up to a stabilized level is easily reflected in the
income capitalization approach, but often needs to be adjusted for in the sales com-
parison approach. The adjustment applied to the sale of a partially leased property
would be different if users favor unleased buildings over those encumbered by leases.
Another issue in some markets is the difference between the owner-user mar-
ket and the investor market. This difference can be significant in markets like office
building markets where one buyer may want the building to be completely empty
so they can move their business into it while the next buyer may want occupancy as
close to 100% as possible to ensure an income stream. In some cases, it is possible for
a single tenant with a long-term lease to prevent the redevelopment of a site.
Calculations of appropriate adjustments for differences in property rights may be
difficult to develop and support. Properly developed adjustments require significant re-
search and diligence, which may be provided by a well-developed market analysis. Ide-
ally, the comparable transactions selected for analysis include the same types of prop-
erty rights as the subject property so that adjustments are not needed or minimized.
Financing Terms
The market value of a clearly identified property interest may be reported in a num-
ber of ways: (1) in terms of cash, (2) in terms of financial arrangements equivalent to
cash, or (3) in other precisely defined terms. An example of the third scenario is the
cash value of the equity interest subject to existing or proposed financing. The trans-
action price of one property may differ from the price of an identical property due to
financing arrangements, and prices paid with advantageous financing must be ad-
justed to account for an additional increment caused by the advantage before using
those prices as an indicator of market value for the subject property. For example, the
purchaser of a property may have assumed an existing mortgage at a favorable inter-
est rate. In another case, the seller rather than the buyer may have paid the buyer’s
closing costs. In both cases, the buyers probably paid higher prices for the properties
to obtain favorable financing. The general availability of financing and the loan-to-
value ratio can be significant factors that influence property value, and the specific
financing terms in a transaction can also affect the price.
Components of financing include the amount of a mortgage loan, its interest
rate, its schedule of debt repayment, required fees for placing the loan, and required
restrictions or fees for early termination of the loan. Any of these components can
affect the cost of financing to the buyer. Typically, nonmarket financing arrangements
include installment sale contracts, in which the buyer pays periodic installments to
the seller and obtains legal title only after the contract is fulfilled, purchase money

mortgages where the seller becomes the mortgage lender, assumptions in which the
new buyer assumes the terms of the previous mortgage loan, and wraparound loans,
which are a combination of assumptions of old mortgage debt with new money
added (a blended rate). Below-market rates are sometimes extended to individuals
who have substantial net worth and are therefore especially creditworthy. This is im-
portant because it means that the cost of financing is not entirely tied to the property
and will be impacted by the applicant.
In cash equivalency analysis, each comparable transaction with financing that
differs from the presumed financing of the property being appraised should be ad-
justed for parity. Appraisers investigate the sale prices of comparable properties that
appear to have been sold with nonmarket financing to determine whether adjust-
ments are needed to reflect cash equivalent terms at the time of sale. Using paired
sales analysis, sales with nonmarket financing are compared to other sales transacted
with market financing to determine whether an adjustment for cash equivalency is
being recognized in the market.
The typical definition of market value recognizes cash-equivalent terms, which
means a sale price that equals the amount paid by a cash buyer who did not need any
assistance or advantages from the seller. Conditions of sale may reveal other interests
on the part of buyers or sellers that are not related to financing terms. Confirmation
of the intent of buyers and sellers is one way to verify a cash equivalency adjustment.
Cash equivalency calculations vary depending on the kind of financing arrange-
ment that requires adjustment. Appraisers may calculate adjustments for atypi-
cal financing by analyzing paired data sets or by discounting the cash flows (e.g.,
payments and balloons) created by the mortgage contract at market interest rates. If
discounting is used, appraisers should not assume that the buyer will always hold
the property for the life of the mortgage. Market evidence often indicates otherwise.
A mortgage is often discounted for a shorter term, but the balloon payment must still
be included. In addition, the benefit of a lower interest rate loan may not be as signifi-
cant in future years as it is now. That is, buyers who obtain favorable financing only
benefit until mortgage rates come back down.
Calculating a cash equivalency adjustment by discounting cash flows can be ac-
complished in different ways. When a seller finances a mortgage at a below-market
interest rate, appraisers can estimate the present value of the mortgage by applying a
present value factor to the monthly mortgage payment at the market interest rate for
the stated term of the mortgage.5 For example, an appraiser finds a comparable sale
of a one-unit residence that was sold for $250,000 with a down payment of $50,000
and a seller-financed mortgage of $200,000 for a 20-year term payable monthly at
3.0% interest. Homes in the market area are typically held for the full 20-year term,
and the market rate is 3.5%. The cash equivalency adjustment is calculated as follows:
Mortgage $200,000, 20 years payable monthly, 3%
Monthly payment $1,109.20
Present value of $1,109.20 per month for 20 years @ market rate of 3.5% $191,254
Indicated adjustment for cash equivalency $8,746
$200,000 - $191,254 = $8,746
5. See the discussion of concessions later in this chapter for more detail on the effect of seller financing (and other forms of seller participation in
the lending process) on value.

The cash-equivalent sale price would then be $241,254 ($250,000 – $8,746). A common
criticism of this calculation is that while the mortgage term may run 20 years, the advan-
tage of the discounted rate would be much shorter. That is, the 3.5% to 3.0 % advantage
would be gone if the market rate comes down to the lower level some date in the future.
Discounting cash flows to calculate a cash equivalency adjustment may also take
into account the expectation of a balloon payment. For example, consider a house
that sells for $250,000 with a down payment of $50,000 and a seller-financed $200,000
mortgage at an interest rate of 3.5% when the market rate is at 6.0%. The mortgage is
amortized over 25 years with a balloon payment due at the end of 8 years. The pres-
ent value of the mortgage is computed as the sum of two components:
1. The present value of the mortgage payments at the market interest rate for the
expected life of the mortgage
2. The present value of the future mortgage balance at the market interest rate
The calculations are as follows:
Mortgage $200,000, 25 years payable monthly, 3.5%
Monthly payment $1,001
Present value of $1,001 per month for 8 years @ 6.0% $76,190
Mortgage balance in 8 years $153,777
PV of mortgage balance in 8 years @ 6.0% $95,269
PV of mortgage $171,459
$76,190 + $95,269 = $171,459
Indicated adjustment for cash equivalency $28,541
$200,000 - $171,459
The cash-equivalent sale price would then be $221,459 ($250,000 – $28,541).

Transactions involving mortgage assumptions can be adjusted to cash equiva-
lency with the same method applied to seller-financed transactions. Other atypical
mortgage terms include mortgages that call for interest-only payments followed by
payments that include the repayment of the principal. This type of mortgage can also
be adjusted to its cash-equivalent value using the adjustment procedure described
here. The present values of the payments (monthly, quarterly, semiannual, or annual)
at the market rate, year by year, are derived using present value factors. If balloon
payments are involved, present value factors may be applied to isolate the contribu-
tory market value of the unpaid balance of the mortgage.
Financing adjustments derived from precise, mathematical calculations of cash
equivalency must be tested against market evidence. Strict mathematical calculations
may not reflect market behavior. It is necessary for appraisers to talk with the buyers
and sellers to determine if the financing terms affected the price. Market evidence
must support the adjustment made. If the cash discount indicated by the calculations
is not recognized by buyers and sellers, the adjustment is not justified.
Appraisers should also recognize that in some situations financing and condi-
tions of sale are interdependent, and they should be careful not to double-count the
influence of these factors when making quantitative adjustments.
Conditions of Sale
The definition of market value used in most assignments requires “typical motivations
of buyers and sellers” with no incentives or pressure on either party to consummate

the sale. An adjustment for conditions of sale usually reflects the motivation of either
a buyer or a seller who is under undue duress to complete the transaction. In many
situations the conditions of sale can significantly affect transaction prices. These are
atypically motivated sales transactions. For example, a developer may pay more than
market value for lots needed in a site assemblage because of the plottage value or
any enhanced development economies expected to result from the greater utility of
the larger site. A sale may be transacted at a below-market price if the seller needs to
complete a transaction before a certain date (e.g., marriage dissolution). A financial,
business, or family relationship between the parties to a sale may also affect the price
of property. Interlocking corporate entities may record a sale at a nonmarket price to
serve their business interests. One member of a family can sell a property to another
member of the family at a reduced price, or a buyer may pay a higher price for a
property because it was built by his or her ancestors.
When nonmarket conditions of sale are detected in a transaction, the sale can
be used as a comparable, but care is needed. The circumstances of the sale must be
thoroughly researched before an adjustment is made, and the conditions must be
adequately disclosed in the appraisal report. Any adjustment should be well sup-
ported with data. If the adjustment cannot be supported, the sale probably should be
discarded or, at the very least, sufficient commentary should be provided to explain
the situation so that the reader understands what has occurred and why the sale is
being used.
Although conditions of sale are often perceived as applying only to sales that are
not arm’s-length transactions, some arm’s-length sales may reflect atypical motiva-
Like-kind Exchanges
Section 1031 of the Internal Revenue Code allows for the exchange of real estate free from the recognition of
the taxable gains or losses that would result from the transfer. Certain conditions must be met for a transfer
of property to qualify:
• There must be an actual exchange and not a sale.
• The properties exchanged must be of like kind.
• The property transferred and the property received must be held for productive use in a trade or business
or for investment.
• The taxpayer must meet the specified timing requirements.*
In other words, a property owner can in essence defer taxation on any gains realized by the disposal of real
estate if a similar property can be acquired within the window allowed by the tax code. The use of this tax-
defferal strategy by owners of business and income property is perennially subject to legal interpretations of
the current wording of the tax code, most recently in 2018 when all asset types other than real estate were
dropped from eligibility.
Property that is transferred in a like-kind exchange does not necessarily sell for more (or less) than its
market value, but these transactions can be complex and transaction costs are often higher than normal.
Buyers in 1031 property exchanges may pay more for a property because they lose the ability to defer taxes
on the gain if they do not meet the timing requirements of the code. For a property involved in a like-kind
exchange to be used as a comparable sale in the valuation of a property that would not be transferred in a
like-kind exchange, an adjustment of the sale price relating to the difference in conditions of sale or a cash-
equivalency adjustment may be necessary. Sale verification is the best way to find market support for this
type of adjustment if one is needed.
* John R. Leavins and Samuel Penkar, “An Overview of Real Estate Like-Kind Exchanges,” The Appraisal Journal (July 2003): 266.

tions or sale conditions for several reasons, including but not limited to unusual tax
considerations, lack of exposure on the open market, or the complexity of eminent
domain proceedings. If the sales used in the sales comparison approach reflect un-
usual situations, an appropriate adjustment (supported by market evidence) should
be made for motivation or conditions of sale. Again, the circumstances of the sale
must be explained in the appraisal report.
In some markets with limited data, appraisers cannot discard any sales and
must use comparable sales with unusual conditions of sale. Too much competition
or a poorly performing market could cause a similar situation. (See Guide Note 11:
Comparable Selection in a Declining Market in the Guide Notes to the Standards of
Professional Practice of the Appraisal Institute for further information.)
Concessions
A concession is a financial payment, special benefit, arrangement, or non-realty item included in a sale
contract or rental agreement as an incentive to the sale or lease. Concessions occur when the seller or lessor
agrees to pay an inducement or to give some special credit or property to a buyer or lessee, who agrees to
pay a higher price than would normally be paid in return for the inducement or credit. Concessions often al-
low financing that would otherwise not be possible, and they usually result in artificially inflated sale prices or
lease rates. Concessions may be disclosed as part of the sale or lease, but they are often not disclosed.
For example, a seller may give some sort of financial incentive to induce a buyer to make an offer on their
property rather than on a competitor’s property. Some appraisers will identify this sort of financial “concession”
as an adjustment to be made under the “conditions of sale” element of comparison, but other appraisers will
label concessions as “financing terms.” The label itself is less important than recognizing the effect of conces-
sions on the sale price of a comparable sale, compensating for that effect, and not double-counting the effect
of the concession. Note that the Uniform Residential Appraisal Report form includes a note that instructs users
of the form that concessions should not be automatically based on “a mechanical, dollar-for-dollar basis.”
Additional examples of concessions include the following:
• A sale that includes personal property items such as automobiles, motorcycles, cruise tickets, or furnishings.
• A sale in which the seller contributes to the buyer’s portion of the closing costs. This lowers the amount of
money the buyer needs at closing. The parties usually raise the selling price by the amount of the extra cost
in order to net the same amount they would with a typical buyer.
• A transaction in which the seller of the real property purchases a piece of personal property from the
buyer at an inflated price. For example, the buyer has a used car worth $2,000, but the seller buys it for
$20,000 (as part of the real property transaction), in effect giving the buyer a down payment. The price
(but not the value) of the real property is artificially increased by $18,000.
• A sale in which the seller subsidizes the buyer’s mortgage, e.g., buys down the interest rate, pays the
buyer’s mortgage payments for a stated number of months, or provides some other arrangement. If the
interest rate of the new loan is lower, some lenders will underwrite the loan at the discounted rate, which
allows the buyer to take out a larger loan.
• A seller-financed sale in which the seller takes back a mortgage at a below-market rate, which will give the
buyer lower payments unless the seller raises the sale price to compensate.
• A free month’s rent as part of a one-year apartment lease.
• A new lease in which the landlord pays the tenant’s moving costs.
• Points paid by the seller.
• Personal property, furniture, fixtures, and equipment (FF&E), or other non-realty items included in the sale.
Verification is key to assessing the influence of concessions. Appraisers should adjust for these items be-
cause a value indication that includes the effect of concessions is usually not in compliance with commonly
used definitions of market value.

Making direct comparisons is more difficult when the motivations of market
participants are atypical. If the buyer is related to the seller, the sale price paid may not
reflect the price that would be paid on the open market. Likewise, if a seller needs the
proceeds of the sale quickly to avoid bankruptcy, a shrewd buyer may be able to pur-
chase the property for less than what it would bring if it were on the market for a rea-
sonable exposure time, allowing more potential buyers to participate in negotiations.
Interviewing the participants involved in the transaction usually provides an
indication of the magnitude of the adjustment, but sometimes the direction of an
adjustment for conditions of sale may be all that can be determined. In the case of a dis-
tressed seller, an upward adjustment may be necessary to reflect the value the seller is
not recapturing by accepting a below-market offer. The direction of a conditions of sale
adjustment in transactions involving related parties may be more difficult to determine.
If the details of the transaction are too difficult to verify, an adjustment for conditions of
sale may not be usable but it can still be discussed and may be useful in reconciliation.
Expenditures Made Immediately After Purchase

A knowledgeable buyer considers expenditures that will have to be made upon pur-
chase of a salable property because these costs affect the price that the buyer agrees to
pay. These expenditures may include
• Costs to cure deferred maintenance
• Costs to demolish and remove a portion of the improvements
• Costs for additions or improvements to the property
• Costs to petition for a zoning change, which also changes the use of the property
• Costs to remediate environmental contamination
These costs are often quantified in price negotiations and, like concessions, can be
discovered through verification of the sale transaction data. The relevant figure is not
the actual cost that was incurred but the cost that was anticipated by both the buyer
and seller at the time of purchase.
Generally, an adjustment for expenditures made immediately after purchase is
simple to quantify when transaction data is being verified with the market partici-
pants. For example, consider a 15,000-sq.-ft. warehouse that is comparable to the
property being appraised and was recently sold for $850,000. The new owner-occu-
pant expected to spend $65,000 to install an overhead door and loading dock, which
was a market-driven decision because nearly all industrial buildings in this market
have at least one door and dock. In an interview with the new owner of this compa-
rable property, the appraiser learns that the proposed changes actually cost $105,000.
The adjusted price for that comparable property would be $915,000 ($850,000 +
$65,000) rather than $955,000 ($850,000 + $105,000) because the $65,000 expenditure
anticipated by the buyer was deducted from the price the property would command
in the market if no expenditures were necessary.
Adjustments for deferred maintenance can be handled similarly, but appraisers
should make sure that both the buyer and seller were aware of any items needing im-
mediate repair. If the seller was not required to disclose or did not necessarily know
that the roof of the warehouse had a leak and needed repairs, the buyer may not have
anticipated those expenditures after the purchase, and there would be no adjustment

to the recorded sale price for that item of deferred maintenance. These factors are
always determined through the personal interviews that are part of the verification
process. Other items that a buyer may need to budget for as expenses immediately
after purchase include
• Cost of obtaining entitlements (permissions)
• Demolition and removal costs
• Environmental remediation costs (unless the buyer is indemnified by the seller or
a third party or the remediation costs are being paid by another party)
• Large capital improvements needed at the time of sale
In sales comparison analysis, costs incurred by the new owners of comparable
properties are reflected as positive adjustments to the sale prices of those properties.
If the subject property requires some expenditure immediately after the purchase to
reach its full utility, the adjustment amount is subtracted from the sale prices of all
comparable sales that do not require a similar expenditure to adjust those transac-
tions for differences from the subject property.
An adjustment for expenditures made immediately after purchase is distinct
from an adjustment for the physical condition of a property. The expenditures ad-
justment is included among the transactional adjustments because it reflects those
items that a buyer would have considered part of the price at the time of the sale.
For example, a buyer bought a property that included a 6.75-acre site improved with
a 122,000-sq.-ft. industrial building with many environmental problems. The buyer
told the appraiser that the cost of removing the building and the environmental prob-
lems was $750,000. The sale price of the property was only $225,000. The appraiser is
considering using this as a comparable land sale, but the buyer actually has $975,000
($750,000 + $225,000) invested in the property, not just the $225,000 sale price. In the
sequence of adjustments, an adjustment for expenditures made immediately after
purchase is shown above the market conditions line, which means the market condi-
tions adjustment would be made on the $975,000 price, not the $225,000 price. Often
a buyer will want to negotiate an even lower price factoring in an entrepreneurial
incentive for doing the work.
Another application of this adjustment is for items that would affect the sale
price but not necessarily the rental income. For example, the subject property is a
55,000-sq.-ft., three-story office building that has a new roof covering and three new
HVAC units. The cost of these items is $252,000. A nearly identical comparable prop-
erty just sold for $5 million, but this property needed a new roof covering and three
new HVAC units. The rental rates of both buildings are the same, but the mainte-
nance expense for the comparable property is much higher. The adjustment for the
deferred maintenance items found in the comparable property could be made on the
condition line of the adjustment grid or on the expenditures made immediately after
purchase line. An adjustment made on the condition line would affect the capitaliza-
tion rate that might be extracted from this sale. In other words, the capitalization rate
would be a reflection of a sale with good income levels but deferred maintenance. If
this adjustment is made prior to extracting the capitalization rate, the result would be
an “apples to apples” comparison rather than the skewed amount that would result
if the capitalization rate were extracted from a sale with the needed repairs.

Market Conditions
Comparable sales that occurred under market conditions different from those ap-
plicable to the subject on the effective date of appraisal require adjustment for any
differences that affect their values. An adjustment for market conditions is made if
general property values have increased or decreased since the transaction dates. The
value of one segment or type of property may change at a certain rate, but this does
not mean that others also change at the same rate. For example, land values may
have increased at a rate of 10% per year for the past 14 months, but this does not
mean that the values of the improved properties have also increased at the same rate
over the same period of time.
Although the adjustment for market conditions is often referred to as a “time”
adjustment, time is not the cause of the adjustment. Market conditions that change
over time create the need for an adjustment, not time itself. In other words, increases
or decreases in property values in the market over time are the cause of the adjust-
ment and time is the basis of the adjustment. If market conditions have not changed,
no adjustment is required even though considerable time may have elapsed.
The timing of comparable sales can provide the basis for a market conditions
adjustment. For example, the highest and best use analyses of vacant land parcels
provide information that can be used to estimate an adjustment for changes in market
conditions. Comparable tracts of vacant land may have been sold under market con-
ditions different from those on the date of the appraisal. The best sales data available
is often historical sales to purchasers who bought the land with a specific use in mind.
These sales provide an indication of the anticipated land value under the specific use.
Changes in market conditions may also result from changes in income tax laws,
building moratoriums, the availability of financing, employment, interest rates, and
fluctuations in supply and demand. Sometimes several economic factors work in con-
cert to cause a change in market conditions. A recession tends to deflate all real estate
values, but specific property types or submarkets may be affected differently. A decline
in demand may affect only one category of real estate. If the demand for a specific type
of property falls during a period of inflation, sales transacted during that period may
not provide a reliable indication of the market value of a similar property in a different
period unless appropriate adjustments are made. In a depressed economy, recent non-
distressed sales are often difficult to find. Older sales, occurring prior to the onset of the
depressed economy, should be used with great caution because they may not reflect
the problems associated with the depressed economy. In some instances when current
sales of improved properties do not exist, upward or downward shifts in rent and rent
terms or land values may help appraisers identify the direction of market activity.
Appraisers must also recognize that the sale of a property may be negotiated
months or even years before the sale closes. The buyer and the seller make an agree-
ment as of the contract date, but the agreement does not become effective until the
closing date, and changes to the agreement are often made in the interim. An adjust-
ment for changes in market conditions between the date the contract is signed and
the effective date of value may be appropriate. Also, sometimes appraisers are called
on to develop an retrospective or prospective opinion of market value, which re-
quires a close study of changes in market conditions.6
6. For USPAP guidance retrospective and prospective value opinions, see Advisory Opinion 34 of the Uniform Standards of Professional Appraisal
Practice, 2020-2021 ed. (Washington, DC: Appraisal Foundation, 2020), 156-157.

An adjustment for changes in market conditions is usually measured as a per-
centage of previous prices. While change is continuous, it is typically measured and
quoted in specific intervals because markets move in cycles rather than in one con-
stant direction. If the physical and economic characteristics of a property remain un-
changed, analyzing two or more sales of the same property over a period of time will
indicate the percentage of price change. In other words, appraisers can measure the
difference in sale prices of the same or similar properties over time to extract the rate
of change, which can then be used as the basis for adjustment in the sales comparison
analysis. Appraisers should always attempt to examine several sets of sales to arrive
at an appropriate adjustment.
Sales and resales of the same properties may provide a good indication of the
change in market conditions over time. However, such an analysis must be ap-
proached with caution because it is possible that a resale of a property involved
nonmarket conditions. For example, if similar properties are typically held for seven
years and the resale occurred after only two years, is it possible that the seller was
compelled to sell? Consider a three-bedroom house that sold three years ago for
$250,000 and then sold again recently for $242,500. The indicated average annual
decline in value of the house would be 1% ([($250,000 - $242,500)/$250,000]/3). In
the same market area, another three-bedroom home with similar characteristics
sold for $260,000 two years ago and then sold again last year for $250,000. The
average annual change for that comparable property is 1.92% per year ([($260,000
- $250,000)/$260,000]/2). The results of additional calculations made using sale and
resale data and paired sales of comparable properties can be reconciled to support an
estimated market conditions adjustment. The transactions used in these additional
calculations should be similar in terms of markets, land-to-building value ratios, and
other elements of comparability.
If there is a change in the price of a property between one period and another,
any changes to the condition of the property during that time need to be accounted
for. Say, for example, that a property sold for $250,000 and then for $300,000 two
years later. During that time, improvements were made to the property that contrib-
uted $25,000 to the value of the property, so the actual change due to market condi-
tions was only $25,000 rather than $50,000. Now consider a scenario that was com-
mon in the last down cycle. A property sold for $300,000 and then, four years later,
sold for $250,000. In that time period, nothing was done to maintain the property,
so all or a portion of the $50,000 decline is likely a result of physical depreciation or
deterioration rather than simply a change in market conditions.
Appraisers must remember that supply and demand are dynamic forces, and
periods of decline are just as probable as periods of growth in real estate markets. For
example, in downward economic cycles, prices fall, and negative market conditions
adjustments are needed in sales comparison analysis involving sales data from those
periods of market decline. Also, in volatile markets an adjustment for market condi-
tions may be needed to account for periods of time in which sale prices fluctuate. For
example, appraisers studying mid-rise office building sales in a metropolitan market
find that steadily rising prices between 2016 and 2017 were followed by a period of
volatility in 2018, then a sharp decline in 2019, then a slow rise to 2016 levels by late
2020, and then another period of stability. Comparable sales that occurred between
2018 and 2020 will require scrutiny because of the changing market conditions dur-

ing that period, whereas comparable sales occurring before and after the dramatic
dip in the market may not require a significant market conditions adjustment.
The appreciation or depreciation in average sale prices in a market does not
necessarily follow a linear pattern. Changes in sale price can also be irregular or
stepped, they can increase or decrease on a compounded basis, or they may require
identifying inflection points or dates on which changes in trends occurred. Statistical
tools such as regression analysis and extrapolation are useful in determining precise
mathematical relationships. However, any statistical model generated from the avail-
able data must reflect market thinking to be useful in the adjustment process.
Sorting and plotting sale and resale data or paired sales data on a graph is an-
other way to determine patterns of change. The reliability of such analyses is affected
by the number of market transactions studied. With sufficient data, unit prices can be
graphed over time to indicate the trend in the market (Figure 21.1). Rents can also be
plotted on scatter diagrams to show differences over time.
If sales of comparable properties are not available, other evidence of shifting
market conditions may include changes in
• The ratio between sale prices and listing prices or between lease contracts and
asking lease rates
• Exposure time
• Listing prices
• Trends in rents
• The number of offers a seller receives and the frequency of backup offers
• The proportion of accepted offers that actually close
• The number of foreclosures
• The number of available properties
• The number of building permits issued and their aggregate value
• Terms of available institutional financing
Figure 21.1 Scatter Diagram with Trendline

$205.00
Sale Price per Sq. Ft. of Gross Building Area
$200.00
0.43
78x + 20
y= 0.20
$195.00
$190.00
$185.00
$180.00
-80 -70 -60 -50 -40 -30 -20 -10 0
Date of Sale (Months Ago)

• Use of seller financing
• Market demographic and retail sales patterns
• Demolition and new construction
Property Adjustments
Property adjustments do not need to be applied in a specific sequence. The typical
property adjustments include
• Location
• Legal characteristics (use/zoning)
• Non-realty components of value
Location
An adjustment for location within a market area may be required when the locational
characteristics of a comparable property are different from those of the subject prop-
erty. Excessive or extreme locational differences may disqualify a property from use
as a comparable sale.
Most comparable properties in the same market area have similar locational
characteristics, but variations may exist within that area of analysis. Consider, for
example, the difference between a residential property with a pleasant view of a park
and one located two blocks away with a less attractive view. Adjustments for location
may also be needed to reflect the difference in demand for various office suites within
a single building, the retail advantage of a corner location, the privacy of the end unit
in a residential condominium project, or the value contribution of an ocean view. The
comparison can also be shown with statistical and graphical analysis. For example,
consider the 21 industrial sales shown in Figure 21.2 as a scatter plot and in Figure
Figure 21.2 Scatter Plot

$310.00
$290.00
$270.00
Sale Price per Sq. Ft.
$250.00
$230.00
$210.00
$190.00
$170.00
$150.00
-60 -50 -40 -30 -20 -10 0
Sale Date (Months Ago)

21.3 as a set of linear regression lines sorted by location within the metropolitan area.
The regression lines in Figure 21.3 are more descriptive and clearly show trends in
sale price over time for each of the four locations. The vertical intercepts along the
regression lines also illustrate differences in sale price attributable to locational differ-
ences that can be used to support adjustments for location.
Figure 21.3 Data Grouped by Location

$310.00
$290.00
$270.00
Sale Price per Sq. Ft.
$250.00
Difference in price between locations
$230.00
$210.00
$190.00
$170.00
$150.00
-60 -50 -40 -30 -20 -10 0
Sale Date (Months Ago)
Central Business District Near Airport and RR Next to Airport Next to Interstate
As another example Table 21.1 Ranking Analysis of Location

of the analysis of lo-
cational differences, Location
consider the data in S
ale No. Interior Corner
Table 21.1, which il- 1 $150.00
lustrates a definite value 2 $100.00
trend difference between 3 $130.00
the interior and corner 4 $140.00
locations of comparable 5 $120.00
convenience stores in 6 $110.00
a market. The ranking 7 $125.00
analysis shows that the 8 $130.00
market is reacting dif- Mean $137.50 $113.80
ferently than expected. Subject property Interior
The common percep- Comparison Similar Inferior
tion is that, for retail
establishments, corner
locations are superior to interior locations. However, the table shows otherwise, and
appraisers must investigate why the data contradicts conventional wisdom. In this
case, intersection congestion seems to be restricting access to corner locations. The

Table 21.2 Lot Size of Comparable Properties property being appraised
has an interior location,
Sale No. Size (Square Feet) Unit Price so comparable sales with
1 11,000 $150.00 corner locations would
2 43,000 $100.00 require upward adjust-
3 19,000 $130.00 ments. Comparable sales
4 13,000 $140.00 with interior locations
5 30,000 $120.00 would require no loca-
6 41,000 $110.00 tion adjustment.
7 27,000 $125.00 To take the analysis
8 26,000 $130.00 further, suppose the unit
sale prices in Table 21.1 are
also affected by other ele-
Table 21.3 Relative Comparison Analysis of Lot Size ments of comparison that
Size could not be measured
10,000– 25,000– 41,000– by quantitative analysis.
Sale No. 20,000 sq. ft. 30,000 sq. ft. 43,000 sq. ft. Qualitative analysis does
1 $150.00 not measure those differ-
2 $100.00 ences but does identify
3 $130.00 discernible value trends
4 $140.00 for different elements. The
5 $120.00 same comparable sales are
6 $110.00 tested for value differenc-
7 $125.00 es attributable to lot size in
8 $130.00 Table 21.2.
Mean $140.00 $125.00 $105.00 As shown in Table
Subject property 26,000 sq. ft. 21.3, the properties with
Relative comparison Superior Similar Inferior 10,000 to 20,000 square
feet require downward
adjustment to the sub-
Table 21.4 Comparable Apartment Properties ject property, while the
properties with 41,000 to
Comparable One-Bedroom Two-Bedroom Incremental Rent
Property Unit Unit for Second Bedroom 43,000 square feet require
A $1,300 $1,400 $100 upward adjustment.
B $1,350 $1,456 $106 The sales with 25,000 to
C $1,400 $1,504 $104 30,000 square feet require
D $1,420 $1,520 $100 no adjustment.
E $1,428 $1,532 $104
Physical Characteristics
F $,1440 $1,542 $102
If the physical
characteristics of a
comparable property
and the subject property differ, each of the differences may require comparison
and adjustment. Physical differences include differences in size, soils, site access,
topography, quality of construction, architectural style, building materials, age,
condition, functional utility, attractiveness, amenities, and other characteristics.
The value added or lost by the presence or absence of an item in a comparable
property may not equal the cost of installing or removing the item. The market dic-

tates the value contribution of individual components to the value of the whole. Buy-
ers may be unwilling to pay a higher sale price that includes the extra cost of adding
an amenity. Conversely, the addition of an amenity sometimes adds more value to
a property than its cost. In other cases, there may be no adjustment to value for the
existence or absence of an item. For example, an extra bathroom in an apartment unit
may contribute an additional $45 per month to market rent, and this amount could
be capitalized to reflect the value attributable to the extra bathroom and to estimate
an appropriate adjustment to comparable sales without an extra bathroom. However,
the cost of adding a new bathroom to an existing apartment unit could be quite dif-
ferent from this.
As another example, consider an apartment complex with both one-bedroom and
two-bedroom units. Average monthly rents for competitive apartment properties are
shown in Table 21.4. If the apartment buildings are otherwise comparable, the incre-
mental rent attributable to a second bedroom could be reconciled at approximately
$102 per month. Given a 5% annual vacancy and collection loss, operating expenses
of 35% of rent collections, and a market-derived overall capitalization rate of 6%, the
value of a second bedroom can be calculated as follows:
Rent per month $102
Gross income per year ($102 × 12) $1,224
Less 5% vacancy and collection loss - 61
Subtotal $1,163
Less operating expenses (35%) - 407
Annual net operating income attributable to second bedroom $756
Capitalized @ 6% $12,600
Based on this analysis, an adjustment could be applied to sales of comparable proper-

ties with unit mixes that differ from the subject property. Note that an extra bedroom
also increases the overall size of a unit. Appraisers often adjust for the size of the
unit, which may be all that is needed to compensate for the extra bedroom. Adjust-
ing for both size and configuration may be appropriate, but adjusting for the size of
the unit and then also for the extra area included in an extra room would likely be
double-counting the influence of the larger unit.
Double-counting the influence of physical characteristics such as the age and
condition of improvements can be a concern for appraisers. For example, appraisers
would expect to need to adjust the sale price of a comparable property that is notably
older than the subject property for the difference in age of the improvements. A po-
tential buyer would logically expect to pay less for an older, dated property because
of its shorter remaining useful life. But, if the improvements of the comparable prop-
erty are judged to be in inferior condition to the newer improvements of the subject
property, a separate adjustment for the inferior condition of the improvements of the
comparable property may overlap with the effects of age already accounted for in the
adjustment for age.
Economic Characteristics
Differences in the economic characteristics of a comparable property such as the
operating expenses or quality of management of that property may require adjust-
ment. This element of comparison is usually applied to income-producing properties
where the differences in economic characteristics affects the income (and thereby the

value) of the properties being compared. Relevant economic characteristics include
operating expenses, quality of management, tenant mix (or credit worthiness of the
tenants), rent concessions, lease terms, lease expiration dates, renewal options, and
lease provisions such as expense recovery clauses. Appraisers must take care not to
attribute differences in the economic characteristics of properties being compared to
differences in real property rights conveyed or changes in market conditions.
Paired data analysis may provide the only persuasive support for adjustments
for differences in the attributes of a property that affect its income such as operating
expenses, management quality, tenant mix, rent concessions, and other characteris-
tics. Some of these characteristics may already be reflected in the adjustment for loca-
tion. For example, a warehouse in a municipality with low property tax rates may
have a higher value than a comparable warehouse in a neighboring community with
higher tax rates, but the difference in value attributable to the tax rates may already
be reflected in the adjustment for location.
Given the problems associated with net income multiplier analysis and the pos-
sibility of double-counting for value influences reflected in other elements of com-
parison, appraisers must take great care in estimating and supporting adjustments
for economic characteristics.
Legal Characteristics
The most comparable properties are the ones with the same or a similar highest and
best use. If comparable sales are scarce, less comparable properties with a different
use or highest and best use may be analyzed and the sale prices may be adjusted
accordingly. Quantitative adjustments for differences in highest and best use are dif-
ficult to support.
In the valuation of vacant land, zoning is one of the primary determinants of the
highest and best use of the property because it serves as the test of legal permissibility.
Thus, zoning or the reasonable probability of a zoning change is typically a primary
criterion in the selection of market data. When comparable properties with the same
zoning as the subject are lacking or scarce, parcels with slightly different zoning but
a highest and best use similar to that of the subject may be used as comparable sales.
These sales may have to be adjusted for differences in utility if the market indicates that
this is appropriate. On the other hand, a difference in the uses permitted under two zon-
ing classifications does not necessarily require an adjustment if the parcels have similar
potential. It is important for appraisers to consider all known restrictions imposed on
development, which may include not only zoning but other land use restrictions as well.
Sometimes, differences in the sale prices of properties with similar, but not
identical, uses can be reduced to compatible units—e.g., price of land per square foot
of permissible building area—and the difference can be attributed to the different
zoning classification requirements. For example, because of differences in parking
requirements or landscaping requirements, site development costs for two parcels
under different zoning classifications may differ even if the parcels have the same
highest and best use. These dissimilarities will be considered by potential buyers and
therefore should be considered by appraisers. Other legal considerations that could
affect value may include environmental requirements, water rights, access, restrictive
covenants, easements, and flood zones.
In many situations, it may be impossible to support a quantitative adjustment for
the different highest and best uses of otherwise comparable sites. In these cases, market

Table 21.5 Recent Land Sales
Sale Size Price per Maximum Maximum Price per Sq. Ft. of
Sale Price (Sq. Ft.) Sq. Ft. FAR Building Area Maximum Building Area
A $738,000 33,541 $22.00 1.00 33,541 $22.00
B $450,000 41,382 $10.87 0.50 20,691 $21.75
C $690,000 60,984 $11.31 0.50 30,492 $22.63
D $2,100,000 100,188 $20.96 1.00 100,188 $20.96
E $2,810,000 140,699 $19.97 1.00 140,699 $19.97
Subject Property 130,680 0.77 100,000
Standard deviation 5.46473 1.025757581
data can be used to support qualitative analysis of the different intensities of use al-
lowed by zoning. For example, consider a 100,000-sq.-ft. office building on a 3.0-acre site
where the current zoning allows for a maximum floor area ratio (FAR) of 0.50. The exist-
ing improvements predate a zoning change. The zoning regulations allow for improve-
ments of equal size to be built if the existing improvements are razed or destroyed. Most
of the comparable properties are in areas zoned for a maximum FAR of 1.0. A quantita-
tive adjustment may be difficult to calculate using paired data analysis, but if a strong
relationship between the zoning and sale price can be determined, the comparable sales
can still be analyzed and considered. The recent land sales in the subject property’s mar-
ket area listed in Table 21.5 are already adjusted for other elements of comparison.
The price per square foot of potential building area has a smaller standard devia-
tion (1.03) and coefficient of variation than the price per square foot of site area (5.47).
The market evidence supports use of the price per square foot of potential building
area as the unit of comparison. The primary remaining difference is size. The relative
comparison analysis shown in Table 21.6 illustrates a value difference attributable to
size. The analysis supports a value estimate similar to the value of Sale D, or $20.96
per square foot of buildable area.
Table 21.6 Relative Comparison Analysis for Office Building

Size
Sale 20,691–30,492 sq. ft. 100,188 sq. ft. 140,699 sq. ft.
A $22.00
B $21.75
C $22.63
D $20.96
E $19.97
Mean $22.13 $20.96 $19.97
Subject property 100,000 sq. ft.
Comparison Superior Similar Inferior
Non-realty Items
Non-realty items include business concerns and other items that do not constitute
real property. In most cases, the economic lives, associated investment risks, rate

of return criteria, and collateral security for the non-realty components differ from
those of the real property. When such items are included in the value opinion for the
subject property, they must be separately identified, and their effect on value must be
analyzed. For some assignments, these items will need to be valued separately. When
these items are valued separately, they are generally valued at their contributory
value to the whole. When analyzing comparable properties, consideration must be
given to whether non-realty items were included in the sale price.
Furniture, fixtures, and equipment in a hotel or restaurant are typical examples of
personal property that may be included in a comparable sale. In appraisals of prop-
erties in which the business operation is essential to the use of the real property, the
contributing value of the non-realty component must be analyzed. If the contribut-
ing value of the non-realty component cannot be separated from the value of the real
property as a whole, an appraiser should make clear that the value indication using
the sales comparison approach reflects both the contributing value of the real estate
and the value of the business operation. Properties such as hotels and timeshare
condominium units, which have higher expense ratios attributable to the business
operation, may include a significant business value component.

Applications of the 22
Sales Comparison Approach
Chapters 20 and 21 described the basic theory and procedures of the sales compari-
son approach and introduced a number of specific techniques. The examples present-
ed in this chapter illustrate the most commonly used techniques of sales comparison.
Quantitative and qualitative techniques may both be employed in the application of
the sales comparison approach. If adjustments can be derived by quantitative tech-
niques, they are generally applied first. Differences in specific elements of compari-
son that elude precise mathematical adjustment are then considered in qualitative
analysis. The two methods are complementary and are often used in combination.
Other techniques can also be used to identify and estimate adjustments. Ap-
praisers should consider all applicable techniques to determine which ones are most
appropriate to the appraisal.
Residential Property Example

The following appraisal problem illustrates the application of quantitative adjust-
ment techniques, qualitative analysis, and an appropriate sequence of adjustments in
the sales comparison approach. The problem solution is presented as it might appear
in an appraisal report.
The subject property is improved with a 25-year-old, single-unit residence on a
single lot. It has the original kitchen, a one-car garage, and no air-conditioning. It con-
tains 1,200 square feet of gross living area. The construction quality of the structure is
average, and the site enjoys a lake view, which is considered an amenity by the market.
Sale A is a current cash sale of a property that was sold for $274,500. The house is
on a double lot and has a modern kitchen, a one-car garage, and no air-conditioning.
The 25-year-old property contains 1,100 square feet of gross living area. The structure
is of average construction quality, but the site does not have the view amenity of the
subject property.
Sale B was sold a year ago for $230,000 with market financing. The 25-year-old
house is on a single lot and has an old kitchen, a one-car garage, and no air-condi-
tioning. It contains 1,150 square feet of gross living area. The house features a similar
view of the lake as the subject property, and the construction quality of the structure
is good.
Sale C is a current cash sale of a property that was sold for $246,000. The 27-year-
old house is on a single lot and has an old kitchen, a two-car garage, and central air-
conditioning. It contains 1,300 square feet of gross living area. The structure is only of
fair construction quality, and the site does not enjoy the same view of the lake as the
subject property. The property was sold two years ago for $223,650.
Sale D is a current sale of a property that was sold for $240,000 with a 90% FHA
loan requiring the seller to pay three points. The improvement is a 29-year-old house
on a single lot with a view of the lake. It has an old kitchen, a one-car garage, and
central air-conditioning. It contains 1,200 square feet of gross living area. The con-
struction quality of the structure is average.
Additional market data includes these facts:
• Sites in this area have a contributory value of $30,000.
• The cost to modernize a kitchen in the subject neighborhood averages $22,500.
However, the appraiser’s study of subsequent sales of homes with modern
kitchens indicates that the market is willing to pay $30,000 more for a home with
a modern kitchen.
• Central air-conditioning is currently available in a new development of similar
homes at a cost of $4,500. Many purchasers elect to have central air-conditioning
installed as an upgrade feature. Although some homes in the subject neighbor-
hood have central air-conditioning, due to a lack of data paired data analysis
cannot be used to derive an adjustment for this feature.
• Most existing homes in the area have one-car garages. A comparison of sales of
houses in the market with two-car garages and the more predominant design of
one-car garages indicates that buyers regularly pay $10,000 more for an existing
home with a two-car garage.
• The average depreciation for homes in the subject property’s neighborhood is ap-
proximately 33.33%.
The first step toward solving the appraisal problem is to array the data by
identifying both typical elements of comparison and those that are apparent from
the problem statement. This type of data array helps an appraiser determine which
adjustments will not have to be made.
Analysis of the array (Table 22.1) indicates that three characteristics—property
rights conveyed, conditions of sale, and expenditures made immediately after pur-
chase—are similar for all the sales and for the subject property. Since these features
are the same for all properties, they cannot account for differences in value and
therefore no adjustments are needed for them on the adjustment grid. Many of the re-
quired adjustments can be derived from information given in the problem statement.
The financing adjustment for Sale D is calculated by multiplying the amount of
the mortgage, $216,000 (90% of a sale price of $240,000), by 0.03 (i.e., the three points).
Thus, the price of Sale D is adjusted downward by $6,480 and the cash-equivalent
price becomes $233,520.
The adjustment to Sale B for market conditions is derived by analyzing the sale
price and resale price of Sale C, which sold two years prior to the current sale for

Table 22.1 Market Data Grid: Elements of Comparison
Subject Property Sale A Sale B Sale C Sale D
Property rights Fee simple Fee simple Fee simple Fee simple Fee simple
Financing Market Cash Market Cash 3 points
Conditions of sale Arm’s-length Arm’s-length Arm’s-length Arm’s-length Arm’s-length
Expenditures made
immediately after purchase None None None None None
Date of sale Current Current 1 year ago Current Current
Improvement age 25 years 25 years 25 years 27 years 29 years
Lot Single Double Single Single Single
Kitchen Old Modern Old Old Old
Garage 1-car 1-car 1-car 2-car 1-car
Air-conditioning No No No Yes Yes
View amenity Lake None Lake None Lake
Construction quality Average Average Good Fair Average
Size (GLA) 1,200 sq. ft. 1,100 sq. ft. 1,150 sq. ft. 1,300 sq. ft. 1,200 sq. ft.
$223,650. The total change over the two-year period was approximately 10.0% or 5.0%
per year. Since Sale B sold one year ago, it is adjusted upward by 5%, or $11,500. After
the adjustment for market conditions, the sale price of Sale B becomes $241,500. The ad-
justment for the double lot in Sale A is $30,000, derived from the market data provided.
The adjustment for the modern kitchen in Sale A is $30,000, also derived from the
market data. In this instance the adjustment is based on the contributory value of the
modern kitchen, not the cost of modernization.
The contributory value of the central air-conditioning in Sales C and D is estimat-
ed to be $3,000. The cost of this feature in new construction is $4,500. Properties in the
subject neighborhood are depreciated by approximately 33.33%. Since property com-
ponents suffer similar depreciation, an air-conditioning system installed in a home in
the subject neighborhood would reflect the overall depreciation of the property. Thus,
the basis of the adjustment is the depreciated cost of the air-conditioning.
Like the adjustment for the modern kitchen, an adjustment to Sale C for the ef-
fect on value of a two-car garage is estimated in this market through analysis of the
contributory value of the larger garage, i.e., the competitive advantage in the mar-
ket of houses with two-car garages over houses with one-car garages. The market
analysis supports an adjustment of $10,000. After all the other adjustments have been
estimated, a market data grid (Table 22.2) can be used to help derive the remaining
adjustment for the difference in garage size.
Adjustments for the last three elements of comparison listed in Table 22.2 can-
not be determined from the available market data, though they should contribute
to differences in value. The value influence of those elements of comparison will be
addressed later in qualitative analysis. At this point, the quantitative adjustments are
applied to generate adjusted sale prices in Table 22.3.
In this example, the range of value opinions is still somewhat broad. Newer
homes generally sell for more than older homes. Sales C and D, which are older than
the subject property, are probably inferior to the subject property, while Sales A and B
are similar.
Applications of the Sales Comparison Approach 399

Table 22.2 Market Data Grid: Quantitative Adjustments
Subject
Property Sale A Sale B Sale C Sale D
Sale price ? $274,500 $230,000 $246,000 $240,000
Financing Market Cash 0 Market 0 Cash 0 3 points -6,480
Cash-equivalent
price $274,500 $230,000 $246,000 $233,520
Date of sale Current Current 0 1 year ago +11,500 Current 0 Current 0
Current cash-
equivalent
price $274,500 $241,500 $246,000 $233,520
Lot Single Double -30,000 Single 0 Single 0 Single 0
Kitchen Old Modern -30,000 Old 0 Old 0 Old 0
Air-conditioning No No 0 No 0 Yes -3,000 Yes -3,000
Garage 1-car 1-car 0 1-car 0 2-car -10,000 1-car 0
Improvement
age 25 years 25 years 0 25 years 0 27 years ? 29 years ?
View amenity Lake None ? Lake 0 None ? Lake 0
Construction
quality Average Average 0 Good ? Fair ? Average 0
Table 22.3 Market Data Grid

Subject
Sale price ? $274,500 $230,000 $246,000 $240,000
Financing Market Cash 0 Market 0 Cash 0 3 points -6,480
Cash-equivalent
price $274,500 $230,000 $246,000 $233,520
Date of sale Current Current 0 1 year ago +11,500 Current 0 Current 0
Current cash-
equivalent
price $274,500 $241,500 $246,000 $233,520
Lot Single Double -30,000 Single 0 Single 0 Single 0
Kitchen Old Modern -30,000 Old 0 Old 0 Old 0
Air-conditioning No No 0 No 0 Yes -3,000 Yes -3,000
Garage 1-car 1-car 0 1-car 0 2-car -10,000 1-car 0
Net adjustments
(for kitchen,
air-conditioning,
and lot) -60,000 0 -13,000 -3,000
Adjusted sale price $214,500 $241,500 $233,000 $230,520
The view of the lake is desirable in this market and should increase property
value. Sales B and D share a similar view as the subject property, but Sales A and C
do not and therefore are probably slightly inferior to the subject property.
The construction quality of the subject property is average, which is similar to
the quality of the structures of Sales A and D. The construction quality of Sale B is

considered good though, which is superior to the subject property, and the quality of
construction of Sale C is only fair, which is inferior to the subject property.
Qualitative analysis of all the attributes of the comparable properties that cannot
be quantified is shown in Table 22.4. The data are then arrayed in descending order
in Table 22.5, bracketing the subject property. The ranking analysis also shows the
overall comparability of each individual comparable to the subject property.
Table 22.4 Qualitative Analysis

Subject
Sale price ? $214,500 $241,500 $233,000 $230,520
Gross living area 1,200 1,100 1,150 1,300 1,200
sq. ft. sq. ft. sq. ft. sq. ft. sq. ft.
Improvement
age 25 years 25 years Similar 25 years Similar 27 years Inferior 29 years Inferior
View amenity Lake None Inferior Lake Similar None Inferior Lake Similar
Construction
quality Average Average Similar Good Superior Fair Inferior Average Similar
Overall
comparability Inferior Slightly Inferior Inferior
superior
Table 22.5 Ranking Analysis

Sale Adjusted Sale Price Overall Comparability
B $241,500 Slightly superior
Subject property
C $233,000 Inferior
D $230,520 Inferior
A $214,500 Inferior
The adjusted price of Sale C serves as the lower boundary of the bracket derived
from qualitative analysis. Sale B is more similar to the subject property than Sale
C with respect to gross living area, improvement age, and view amenity. Sale B is
superior with respect to construction quality while Sale C is inferior in this respect.
Thus, with more weight given to the indication from Sale B, the value of the subject
property is estimated to be $240,000.
Office Building Example

The property being appraised is a five-year-old, mid-rise, multitenant office build-
ing with 36,000 square feet of gross building area (GBA) and 31,800 square feet of
rentable area (88% of GBA). Its occupancy rate is 90%, which is considered stable in
the subject market area. The amount of space occupied by individual tenants ranges
from 2,500 square feet to 7,000 square feet. The building is of average construction
quality and is in average condition as compared to competing buildings. The ratio of

rentable area to gross building area (88%) is low in comparison to the average ratio in
the subject market area, which is approximately 91%. The site is appropriately land-
scaped. The open-space parking provided is both adequate and in compliance with
the zoning code (6.0 spaces per 1,000 gross square feet). The location, which may also
be considered average, is an interior site accessed from a major arterial highway.
Current base rents range from $24.00 to $26.00 per square foot of rentable area
per year. Rent for the overall building averages $25.20 per square foot and the quality
of the tenants is good. With the exception of telephone service, the landlord pays all
expenses, including janitorial and electrical service. Operating expenses are typical
for the market. The leases have three- and four-year terms and contain an option to
renew for three more years at the then-current market rent. All leases were signed
less than 18 months ago, and the rents and terms reflect the current market.
Five comparable sales are used in the analysis. All the comparable properties are
mid-rise, multitenant office properties located in the subject property’s market area,
and all were financed at market rates with conventional loan-to-value ratios. The unit
of comparison employed in this analysis is price per square foot of rentable area. The
five comparable sales are described below (as of the date of sale), and the analysis is
summarized in Table 22.6:
• Sale A sold nine months ago for $5,860,000. The improvements are six years
old and in average condition. The building contains 40,000 square feet of gross
building area and 37,600 square feet of rentable area (94% of GBA). The indicated
price per square foot of rentable area is $155.85. Average rent is $25.60 per square
foot of rentable area. The landlord pays all expenses, and occupancy is 87%. The
rents, lease terms, and expenses of the property are at market levels. The site is
located at the intersection of a major arterial highway and a collector road. Park-
ing is adequate, at a rate of 6.0 spaces per 1,000 square feet of gross building area.
• Sale B sold four months ago for $4,240,000. The building is four years old and
contains 32,000 square feet of gross building area and 29,700 square feet of rent-
able area (93% of GBA). Its unit price is $142.76 per square foot of rentable area.
Site improvements are average, and the ratio of parking spaces to rentable area is
similar to that of the subject property. The property is in average condition. The
leases provide tenants with full services. Occupancy is 85% and the average rent
is $23.60 per square foot of rentable area, which is below the market rate. The
lengths of the leases are considered to be at market terms. The total expenses for
the building are slightly higher than is typical for the market because two tenants
who occupy 15% of the total space use excessive electricity and do not pay ad-
ditional rent to compensate for the extra expense. The property is located on an
interior site accessed from a collector street. Parking is adequate.
• Sale C was sold five months ago for $4,900,000. The building contains 35,000
square feet of gross building area and 32,200 square feet of rentable area (92% of
GBA). Its unit price is $152.17 per square foot of rentable area. The improvements
were constructed five years ago and are in average condition. Rent averages $25.20
per square foot of rentable area. All tenant services are provided by the landlord.
The building has an occupancy rate of 90%, and all rents, lease terms, and expense
categories are considered to be at market levels. The property’s location is at the
intersection of a collector road and a major arterial highway. The property has a
parking ratio (zoning minimums) equal to that of the subject property.

Table 22.6 Market Data Grid
Subject
Property Sale A Sale B Sale C Sale D Sale E
Sale price/unit price (rentable area) – $5,860,000 $155.85 $4,240,000 $142.76 $4,900,000 $152.17 $4,000,000 $149.81 $4,940,000 $146.15
Real property interest conveyed Leased fee Leased fee Leased fee Leased fee Leased fee Leased fee
Age 5 years 6 years 4 years 5 years 6 years 4 years
Gross building area 36,000 sq.ft. 40,000 sq.ft. 32,000 sq.ft. 35,000 sq.ft. 30,000 sq.ft. 38,000 sq.ft.
Rentable area 31,800 sq.ft. 37,600 sq.ft. 29,700 sq.ft. 32,200 sq.ft. 26,700 sq.ft. 33,800 sq.ft.
Rental area ratio 88% 94% 93% 92% 89% 89%
Occupancy rate 90% 87% 85% 90% 95% 90%
Avg. rent per sq. ft. rentable area $25.20 $25.60 $23.60 $25.20 $25.20 $21.50
Elements of Comparison
Real property rights conveyed— Market rate Above-market rate -$0.23 Below-market rate $0.91 Market rate $0.00 Market rate $0.00 Below-market rate $2.11
differences in rental rate
Rent-up adjustment 90% occupancy 87% occupancy $0.87 85% occupancy $1.45 90% occupancy $0.00 95% occupancy -$1.45 90% occupancy $0.00
Adjusted unit price $156.49 $145.12 $152.17 $148.36 $148.26
Financing terms Conventional Conventional – Conventional Conventional – Conventional – Conventional
Conditions of sale Arm’s-length sale Arm’s-length sale – Arm’s-length sale – Arm’s-length sale – Arm’s-length sale – Arm’s-length sale –
Expenditures immediately after – None – None None – $100,000 in $3.75 None –
purchase deferred
maintenance
Adjusted unit price – $156.49 $145.12 $152.17 $152.11 $148.26
Date of sale 4.0% 9 months ago 3.00% 4 months ago 1.33% 5 months ago 1.67% 2 months ago 0.67% 6 months ago 2.00%
Adjusted unit price – $161.19 $147.06 $154.71 $153.13 $151.23
Construction quality and condition Average Average Average Average Average Average
Ratio of parking spaces to rental area Adequate Similar Similar Similar Inferior Similar
Location Average Superior Inferior Superior Superior Inferior
Expense ratio Market norm Similar Inferior Similar Similar Similar
Overall comparability – Superior Inferior Superior Superior Inferior
Value indication – Less than $161.19 More than $147.06 Less than $154.71 Less than $153.13 More than $151.23
Market rental rate $25.20 $25.20 $25.20 $25.20 $25.20 $25.20
Comparable sales rate $25.60 $23.60 $25.20 $25.20 $21.50
Difference -$0.40 $1.60 $0.00 $0.00 $3.70
1 - Expense ratio 43% 0.57 0.57 0.57 0.57 0.57
Adjustment amount -$0.23 $0.91 $0.00 $0.00 $2.11
Occupancy rate 90% 87% 85% 90% 95% 90%
Difference 3% 5% 0% -5% 0%
Difference in rentable area to equal
occupancy of subject property 1,128 sq.ft. 1,485 sq.ft. 0 sq.ft. -1,335 sq.ft. 0 sq.ft.
Average TI and broker fees per
rentable sq. ft. $29.00 $29.00 $29.00 $29.00 $29.00
Applications of the Sales Comparison Approach

Cost for TI and broker fees $32,712 $43,065 $0 -$38,715 $0
Unit cost for TI and broker fees
(per rentable sq. ft.) $0.87 $1.45 $0.00 -$1.45 $0.00
Adjustment amount $0.87 $1.45 $0.00 -$1.45 $0.00
403
• Sale D was sold two months ago for $4,000,000. The building is six years old and
in average condition, but it needed a new HVAC system at the time of sale. This
was estimated to cost $100,000. Sale D contains 30,000 square feet of gross build-
ing area and 26,700 square feet of rentable area (89% of GBA). The unit price is
$149.81 per square foot of rentable area. The rent averages $25.20 per square foot
of rentable area, and the lease terms and building expenses are at market levels.
The occupancy rate is 95%. The site is located in a superior location, next to the
intersection of two major arterial highways. The owner got a building permit for
this property by dedicating part of an adjacent site that she owned as part of the
parking lot for this building. Since she shifted some of the adjacent land to this
property, both properties now have below-minimum parking ratios and the ten-
ants are always complaining about it. Sale D now has a parking ratio of only 4.0
spaces per 1,000 square feet of gross building area.
• Sale E was sold six months ago for $4,940,000. The building was constructed
four years ago and is in average condition. It contains 38,000 square feet of gross
building area and 33,800 square feet of rentable area (89% of GBA). Its unit price
is $146.15 per square foot of rentable area. The location is an interior site accessed
by a collector street. The occupancy rate for the building is 90%. Rents average
$21.50 per square foot of rentable area. Full tenant services are provided by the
landlord. Rents, lease terms, and property expenses are at market levels. The
property has adequate parking, and the parking ratio is similar to that of the
subject property.
In this case, the appraiser first analyzes the market data and determines that all of
the office building sales involved the transfer of a fee simple estate subject to existing
leases. Adjustments must be made, however, to account for the below-market rents of
Sales B and E and the above-market rate of Sale A. These adjustments account for the
lost net income because the lease rates are lower than the subject property’s on aver-
age, giving certain comparable properties positive and negative leaseholds.
Because the comparable properties have differences in both occupancy and rental
rates, the adjustment grid includes adjustments for real property rights conveyed and
a separate rent-up adjustment. The second adjustment is for the differences in the oc-
cupancy and is intended to account for the cost of paying for real estate broker servic-
es to bring in a new tenant. This also includes the tenant improvement expense that
is often required as part of the lease terms. Because the lease-up process affects the
net income—and thereby the value of the leased fee interest—some appraisers make
rent-up adjustments as part of the adjustment for real property rights conveyed.
Others devote a separate line-item in an adjustment grid to differences in occupancy
to avoid confusion with other property rights issues. The rate of adjustment is based
on an average expense for tenant improvements (TIs) and broker fees of $29.00 per
square foot. Note that the calculation of the adjustments for nonmarket rental rates
and differences in occupancy are shown below the value indications in the table.
All of the comparable properties were sold with conventional market financing,
so no adjustments for this element of comparison are required. All of the transactions
were conducted at arm’s length and no adjustments for conditions of sale are necessary.
The buyer of Sale D invested an additional $100,000 in repairs immediately after
the sale for deferred maintenance on the building’s HVAC system. The appraiser
confirmed with both the buyer and the seller in the transaction that both parties

considered the $100,000 cost of those repairs in their negotiations. As a result, the
appraiser adjusted the reported unit price by $3.75 per square foot ($100,000/26,700
rentable square feet). The other sales required no adjustments for expenditures made
immediately after purchase.
According to the appraiser’s market analysis, prices in the local office property
market had been stable for several years as the market absorbed excess supply. Two
years ago, sale prices began to rise as demand for office space increased. Market
research revealed that the sale prices of similar properties rose 3% over the first year
and that rate jumped up to a 4% increase over the course of the current year. Although
the comparable sales used were generally recent transactions, all occurring within
nine months of the date of valuation, this time period saw active market growth.
The appraiser examined the physical elements of comparison to determine if
market evidence supported additional quantitative adjustments. Additional informa-
tion on the sale of comparable properties revealed general value trends but did not
support quantitative adjustments for these elements.
A relative comparison analysis of the physical elements of comparison is de-
scribed below.
• Sale A has an adjusted unit price of $161.19 per square foot of rentable area. Its
location at the intersection of a major arterial highway and a collector road is
superior to the location of the subject property. The building occupancy rate for
the leased building in Sale A is slightly lower than the subject’s and lower than
the rate considered typical for stabilized occupancy in the market. In short, Sale
A has more superior than inferior attributes and these attributes are considered
more significant. This sale indicates a unit value for the subject property of less
than $161.19 per square foot of rentable area.
• Sale B has an adjusted unit price of $147.06 per square foot of rentable area. Effec-
tive contract rent is slightly lower than market rent. The location of this property
on a collector street is inferior to the subject property’s location on a major arte-
rial highway. The occupancy rate for the comparable property is below the mar-
ket rate for stabilized occupancy, and the expense ratio for the property is slightly
higher than typical, resulting in a lower net income. In all, more of the attributes
of Sale B are inferior than superior and these inferior factors are also considered
more significant. Therefore, the analysis of Sale B indicates that the subject should
have a unit value greater than $147.06 per square foot of rentable area.
• Sale C has an adjusted unit price of $154.71 per square foot of rentable area. The
location of the property is superior to that of the subject. Sale C is superior to
the subject overall, and the value for the subject should be less than $154.71 per
square foot of rentable area.
• Sale D has an adjusted unit price of $153.13 per square foot of rentable area. Be-
cause it is situated at the intersection of two major arterial highways, the property
has a significantly superior location compared to that of the subject. The avail-
ability of parking is limited, which is inferior. Sale D has a higher occupancy rate
than the stabilized occupancy rate that characterizes the market for this type of
property. The superior location and higher occupancy outweigh the limited park-
ing. Overall, this property is superior to the subject property, and an appropriate
value for the subject would be less than $153.13 per square foot of rentable area.

• Sale E has an adjusted unit price of $151.23 per square foot of rentable area. The
location of the property on a collector street is inferior to that of the subject. The
property is similar to the subject in all other elements of comparison. Since Sale
E has an inferior location, the price of the subject should be greater than $151.23
per square foot of rentable area.
The value indications
Table 22.7 Bracketing the Subject Property’s Value derived from the compa-
rable sales are reconciled
Sale Inferior Superior
into a value bracket by
A $161.19
arranging the five sales
C $154.71
in an array relative to
D $153.13
the subject (Table 22.7).
E $151.23
The range of the adjusted
B $147.06
sales is $161.19 to $147.06
and the bracket for the
subject is $151.23 to $153.13 per square foot of rentable area. Sale C is the property
most similar to the subject and therefore is given the greatest weight.
Reconciliation
Based on the indicated range of value and the weight placed on Sale C, the market
evidence supports a value estimate of $153.00 per square foot of rentable area, which
is in the upper range of the value bracket. The market value of the subject property
would then be calculated as follows:
$153.00 × 31,800 = $4,865,400
Note that $4,865,400 implies precision that is beyond the limits of this analysis with
this data, so appraisers could round this opinion of value to $4.9 million to reflect the
precision of the market. (Different appraisers and different clients may use different
rounding conventions.) Rounding indications of value to a final opinion requires
logic and cannot be used as a way to manipulate a value opinion.
Industrial Building Example

The property being appraised is a 30-year-old, owner-occupied warehouse contain-
ing 25,000 square feet of gross building area and 2,500 square feet of finished office
area. The ceiling height is 18 feet. The quality of construction is good and the build-
ing’s condition is average. The fee simple estate of the subject is being valued.
Sales of five comparable properties were found in the subject property’s market
area. All of the properties are warehouses with building-to-land ratios similar to the
subject property.
• Sale A was sold one year ago to an owner-occupant for $1,244,000. The seller pro-
vided advantageous financing that resulted in the buyer paying 10% more than
if the buyer had paid cash (i.e., a purchase-money mortgage). This adjustment
is not exactly 10% of the gross price, since the gross price was increased by the
financing. The calculation would be $X × 110% = $1,244,000, which means that
the price without the financing benefit would be $1,244,000/1.10 = $1,130,909. The
difference in price is $113,091. The property is a 28,000-sq.-ft. warehouse with an

18-ft. ceiling height and 2,750 square feet of finished office area. It was 25 years
old at the time of sale. The quality of construction is good, but at the time of sale
the warehouse exhibited deferred maintenance. When the appraiser verified the
details of the transaction with the parties in the sale, the buyer reported bud-
geting for costs of $35,000 to repair the deferred maintenance, which the buyer
considered in determining the price.
• Sale B was sold six months ago to an owner-occupant for $1,060,000 in a cash
payment to the seller. This 27,000-sq.-ft. warehouse has 18-ft. ceilings and 2,200
square feet of finished office area. It was 23 years old. The quality of construction
and condition are average.
• Sale C is a current sale transacted for $990,000. The buyer assumed an existing
loan at below-market rates. This favorable financing resulted in the buyer pay-
ing $9,000 more than if the buyer had obtained financing at market terms. This
22,000-sq.-ft. warehouse has 17-ft. ceilings and 3,000 square feet of finished office
area. The property is 20 years old. The quality of construction is good and its
condition is average. This warehouse is subject to a long-term lease at a below-
market rate, which resulted in the price being 5% less. The adjustment to the sale
price of Sale C would be calculated as $990,000/0.95 = $1,042, 105. The adjustment
amount is, therefore, $52,100 (i.e., $1,042,100 - $990,000).
• Sale D sold three months ago to an owner-occupant for $1,108,000. This
25,000-sq.-ft. warehouse has a 19-ft. ceiling height and 2,500 square feet of fin-
ished office area. It is 35 years old. The quality of construction is good and the
condition is average due to regular maintenance and upkeep.
• Sale E is a current sale for $1,252,000 paid in cash to the seller. This 26,000-sq.-ft.
warehouse has 18-ft. ceilings and 2,100 square feet of finished office area. The
building is 35 years old. The quality of construction is good, and the condition is
average. The property is subject to a long-term lease that is above market levels.
This lease also caused an adjustment equal to the increase in price due to the fact
that it is above market and long term. The other terms of the lease are similar
to the terms that would be expected in the market. The increase is 10%, so the
calculation would be $X × 1.10 = $1,252,000. The price without the increase would
be $1,252,000/1.10 = $1,138,182. The price was increased by $113,818.
Quantitative Adjustments
The quantitative adjustment procedure is summarized in Table 22.8 and described
below. Notice that in Table 22.8 the sale price was subtotaled after each transactional
adjustment. There is a suggested order of adjustment, but the order of the adjust-
ments does not matter as long as they are added together or multiplied as in this
example. Table 22.8 shows quantitative adjustments for the transactional adjustments
but qualitative analysis for the physical elements of comparison. In this analysis,
other attributes such as rail siding, site size, docks, and overhead doors are assumed
to be the same.
Property Rights Conveyed

Sales C and E were sold subject to long-term leases, so both require an adjustment for
property rights conveyed. Sale C was adjusted upward for the below-market lease,
and Sale E was adjusted down for the above-market lease.

408
Table 22.8 Quantitative Adjustments
Subject
Property Sale A Sale B Sale C Sale D Sale E
The Appraisal of Real Estate

Price – $1,244,000 $1,060,000 $990,000 $1,108,000 $1,252,000
Area in square feet 25,000 sq. ft. 27,000 sq. ft. 27,000 sq. ft. 22,000 sq. ft. 25,500 sq. ft. 26,000 sq. ft.
Ceiling height 18 ft. 18 feet 18 feet 17 feet 19 feet 18 feet
Age 30 years old 25 years old 23 years old 20 years old 35 years old 35 years old
Construction quality Good Good Average Good Good Good
Office area 2,500 sq. ft. 2,750 sq. ft. 2,200 sq. ft. 3,000 sq. ft. 2,500 sq. ft. 2,100 sq. ft.
Elements of comparison
Property rights conveyed Fee simple Fee simple 0.0% Fee simple 0.0% Leased fee 5.0% Fee simple 0.0% Leased fee -10.0%
Adjusted sale price $1,244,000 $1,060,000 $1,042,100 $1,108,000 $1,138,200
Financing terms Cash Private -10.00% Cash to 0.00% Loan -$9,000 Cash to 0% Cash 0%
mortgage seller assumption seller
Conditions of sale Arm’s length Arm’s length 0.0% Arm’s length 0.0% Arm’s length 0.0% Arm’s length 0% Arm’s length 0%
Expenditures made immediately after None Deferred $35,000 None 0.0% None 0.0% None 0.0% None 0.0%
purchase maintenance
Market conditions Current 12 months 4.00% 6 months 2.00% 0 months 0.00% 3 months 1.00% 0 0.00%
Condition of improvements
(after repairs) Average Average 0.00% Average 0.00% Average 0.00% Average 0.00% Average 0.00%
Adjusted price per sq. ft. $44.47 $40.04 $46.96 $43.89 $43.78
Financing Terms
Sales A and C require adjustment for financing terms. The seller of Sale A pro-
vided advantageous financing that resulted in the buyer paying 10% more than the
buyer would have paid in a cash transaction. Therefore, a downward adjustment
of $124,400 is made to Sale A. The buyer of Sale C assumed an existing loan, with a
below-market interest rate. The buyer paid a $9,000 premium above the price that
would have been paid under market terms, so a downward adjustment of $9,000 is
made to Sale C.
Conditions of Sale
All the comparable sales were arm’s-length transactions and none require an adjust-
ment for conditions of sale.
Expenditures Made Immediately After Purchase

Sale A suffered from deferred maintenance. At the time of sale, the buyer anticipated
spending $35,000 to upgrade the building to average condition.
Market Conditions
The sales occurred over a 12-month period. Market analysis shows that properties in
this market have been appreciating at 4% annually. Sales A, B, and D require upward
adjustments for change in market conditions.
Condition of Improvements
The subject property is in average condition. Recall that Sale A was adjusted upward
by $35,000 for expenditures made immediately after purchase to bring it in line with
the subject property’s condition. Another adjustment would not be made for the
property’s condition at the time of sale because, after correcting for deferred mainte-
nance, the property was considered to be in average condition. Appraisers must be
careful to not adjust for the same item twice, since expenditures immediately after
purchase and condition of the improvements may be closely related.
Adjusted Unit Prices

After applying all known quantitative adjustments, the comparable sales indicate
a value range from $40.04 to $46.96 per square foot. Once quantitative adjustments
are made, the sales may be analyzed for qualitative differences that will help in the
reconciliation process.
Qualitative Analysis
Using qualitative analysis, the sales information can be reviewed in the sales compar-
ison grid with reasonable confidence. There are several tools available to extract more
adjustments from the market, but that can be a problem with this limited amount of
data. Many factors unknown to appraisers can impact the price, so the extraction of
precision adjustments from this limited data is often difficult, if not impossible.
Table 22.9 shows a value trend for the ratio of office area to total building area
within the comparable properties. The properties with a higher percentage of office
space had a higher average unit price than the properties with a smaller percentage
of office space.
After relative comparison analysis, the value bracket was $40.04 to $46.96 per
square foot, with Sales A and D ($44.47 and $43.89 per square foot, respectively) most

Table 22.9 Relative Comparison: Ratio of Office Area to similar to the subject
Total Building Area property. If the bracket of
values were broader—for
8% 10% 14% example, if the adjusted
Sale A $44.47 unit prices of Sales A and
Sale B $40.04 D ranged from $35.00 to
Sale C $46.96 $50.00—appraisers could
Sale D $43.89 analyze the comparable
Sale E $43.78 sales further to determine
Subject property 10% if the subject is more
Relative comparison Inferior Similar Superior similar to the sales in the
upper or lower ends of
the bracket.
Table 22.10 Relative Comparison: Construction Quality Other elements of
Poor Average Good Excellent comparison may affect
Sale A $44.47 the adjusted unit prices
Sale B $40.04 of comparable sales to
Sale C $46.96 some degree. Apprais-
Sale D $43.89 ers can prepare data
Sale E $43.78 arrays for each of the
Subject property Good other physical charac-
Relative comparison Inferior Inferior Similar Superior teristics that may have
an effect on unit price
(Tables 22.10, 22.11, and
Table 22.11 Relative Comparison: Age of Improvements 22.12), but if the market
evidence does not show
20–25 30 35 discernible trends for
Sale A $44.47 these elements of com-
Sale B $40.04 parison individually or
Sale C $46.96 as a group, then no ad-
Sale D $43.89 ditional analysis would
Sale E $43.78 be necessary.
Subject property 30 The range of adjusted
Relative comparison Superior Similar Inferior unit prices for inferior or
superior sales may over-
lap the range set by sales
Table 22.12 Relative Comparison: Ceiling Height of different overall com-
17 feet 18 feet 19 feet parability (Table 22.13).
Sale A $44.47 For example, suppose
Sale B $40.04 Sale D had an adjusted
Sale C $46.96 unit price of $42.75 per
Sale D $43.89 square foot, which is less
Sale E $43.78 than the unit price of Sale
Subject property 18 feet E, an “inferior” property.
Relative comparison Inferior Similar Superior In that situation, apprais-
ers need to address the
causes for the overlap and

refine the value bracket. Table 22.13 Overall Comparability
Comparing the ranges
of inferior, similar, and Sale A Sale B Sale C Sale D Sale E
superior properties can Percentage of
office space Similar Inferior Superior Similar Inferior
help appraisers identify
Construction quality Similar Inferior Similar Similar Similar
statistical outliers—i.e.,
Age of improvements Superior Superior Superior Inferior Inferior
observations that are ex-
Ceiling height Similar Similar Inferior Superior Similar
treme and often evidence
Overall comparability
Superior Inferior Superior Similar Inferior
of an error. An outlier may
Adjusted unit price $44.47 $40.04 $46.76 $43.89 $43.78
have an inordinate effect
on a statistical model if the
reason for its departure
Table 22.14 Ranking Analysis
from the typical range
cannot be explained. Comparable Price per Square Foot Overall Comparability
A ranking analysis of C $44.76 Superior
the comparable sales by A $44.47 Superior
their overall comparabil- Subject property
ity (Table 22.14) illus- D $43.89 Similar
trates how an estimate of E $43.78 Inferior
the price per square foot B $40.04 Inferior
of the subject property
could be bracketed by the
adjusted unit prices of
the comparable sales.
Reconciliation
The quantitative adjustments and qualitative analysis in the table give an indication
of value that will allow an appraiser to weigh the reliability and comparability of
the sales in relation to the subject. This data does not give an indication to the near-
est $0.25 per square foot, but it does indicate that a value opinion in the low $40s per
square foot is reasonable. Based on the array of adjusted prices, the subject tends to
fall within the $43.89 to $44.47 adjusted prices of Sale D and A. The bracket supports
a value of about $44.00.
25,000 square feet @ $44.00 = $1,100,000
While there is plenty of room for discussion and disagreement with this conclu-
sion, it is not an unreasonable conclusion since appraisers seldom know every detail
about the comparable sales. There are also considerations that may not be reflected in
this analysis, such as buyer confidence in the market, jobs and employment numbers,
interest rates, and even lending/credit ratios and federal fiscal policy.
Note that the examples in this chapter use a combination of quantitative and
qualitative adjustments. Many appraisers, particularly in the residential lending
world, only use quantitative adjustments.

The Income Capitalization 23
Approach
Income-producing real estate is typically purchased as an investment, and from

an investor’s point of view earning power is the critical element affecting property
value. A basic investment premise holds that the higher the earnings, the higher the
value, provided the risk remains constant. An investor purchasing income-producing
real estate is essentially trading present dollars for the expectation of receiving future
dollars. The income capitalization approach to value consists of methods, techniques,
and mathematical procedures that an appraiser uses to analyze a property’s capacity
to generate benefits (i.e., usually the monetary benefits of periodic income and rever-
sion from a future sale) and convert these benefits into an indication of present value.
The analysis of cost and sales data is often an integral part of the income capi-
talization approach, and capitalization techniques are
frequently employed in the cost and sales comparison
approaches as well. Capitalization techniques can be In the income capitalization
used to analyze and adjust sales data in the sales com- approach, an appraiser ana-
parison approach. In the cost approach, obsolescence is lyzes a property’s capacity to
often measured by capitalizing anticipated shortfalls. generate future benefits and
The income capitalization approach is part of the over- capitalizes the income into an
indication of present value.
all systematic valuation process, and its methods, tech- The principle of anticipation is
niques, and procedures have broad applicability in the fundamental to the approach.
analysis and valuation of income-producing properties. Techniques and procedures
This chapter provides a broad overview of the from this approach are also
income capitalization approach and discusses the prin- used to analyze compa-
rable sales data in the sales
ciples and rationale on which it is based. Chapters 24 comparison approach and to
through 27 continue this discussion with detailed expla- measure obsolescence in the
nations of the specific methods, techniques, and proce- cost approach.
dures used to project and capitalize future benefits.
Anticipation and Change
Anticipation is fundamental to the income capitalization approach. All income capi-
talization methods, techniques, and procedures forecast anticipated future market
benefits and analyze their present value. This may involve explicitly forecasting and
discounting anticipated future income from a property (yield analysis) or determin-
ing a capitalization rate that implicitly values the anticipated pattern of income over
time (direct capitalization).
The approach must also reflect how changes in the amounts and timing of
income affect the value of income-producing properties. To provide sound value
indications, appraisers must carefully research and forecast market expectations of
change in income and the expenses required to sustain income over time as well as
market-anticipated increases or decreases in property value from the present time
to reversion. The defined income of a real estate investment may differ according to
the type of investor. Securitization and globalization of real estate investments has
brought new participants into the market and exhibit influence on market value. For
example, real estate investment trusts (REITs) and pension funds may forecast net
operating income differently than traditional investors.1 Furthermore, foreign inves-
tors may have distinctly different yield expectations and anticipated holding periods.
The capitalization process must reflect the possibility that the actual future in-
come, expenses, and value at reversion may differ from those originally anticipated.
Less forecast certainty means a riskier investment. Investors expect to earn higher
rates of return as perceived investment risk increases. This is reflected in variations in
discount and capitalization rates.
Supply and Demand

The principles of supply and demand and the related concept of competition are
particularly useful in forecasting future benefits and estimating rates of return in the
income capitalization approach. Both anticipated net operating income and rates of
return are drawn from the market.
If the demand for a particular type of space exceeds the existing supply, owners
may be able to increase rents, vacancy rates may fall, and construction may become
profitable. Property values may increase until supply and demand approach equi-
librium. On the other hand, if the demand for space is less than the existing supply,
rents may decline and vacancy rates may increase. Therefore, to forecast future ben-
efits and estimate rates of return, appraisers consider present and future anticipated
demand as well as the interaction of supply and demand.

Any property or property interest that has the potential to generate income can be
valued using the income capitalization approach. When more than one approach is
used to develop an opinion of value for an income-producing property, the value
indication produced by the income capitalization approach might be given greater
1. For a discussion of how pension fund managers and other institutional investors analyze income and cash flow to property, see the discussion of
the securitization of real estate markets in Chapter 10.

weight than that of the other approaches in the final reconciliation of value indica-
tions. The usefulness of the approach will depend on the property type, the property
rights appraised, the quantity and quality of the available data, and the typical inves-
tor profile.
Valuation techniques involving the income generated by the property are in-
tended to reflect investor behavior. For example, investors in small residential income
properties might typically purchase on the basis of gross income multipliers (GIMs)
or effective gross income multipliers (EGIMs). Thus, an appraiser could develop an
opinion of the value of a subject property using the appropriate multiplier. Similarly,
investors in large office buildings with numerous tenants might project future cash
flows by analyzing each lease and considering the effect of lease renewals or lease ex-
tensions and the anticipated sale of the property at the end of a projection period. An
appraiser may simulate this process by conducting a discounted cash flow analysis
for the subject property.
Interests To Be Valued
Income-producing real estate is usually leased. Once a lease is created the fee simple estate is split into two
partial interests: the landlord’s interest (i.e., the leased fee) and the tenant’s interest (i.e., the leasehold).
The interest to be valued depends on the intended use and intended user of the appraisal. Federal or state
law often requires appraisers to value leased properties as fee simple estates, not leased fee estates, for
eminent domain and ad valorem taxation. When the fee simple interest is valued, the presumption is that the
property is available to be leased at market rates. When an appraisal assignment involves the valuation of
the fee simple interest in a leased property, the valuation of the entire bundle of rights applies. The value of a
leasehold estate may be positive, zero, or negative, depending on the relationship between market rent and
contract rent, the remaining term of the lease, and other factors, as explained in Chapter 7. The difference
between the market rent and contract rent may be capitalized at an appropriate rate or discounted to present
value to produce an indication of the leasehold value, if any, without consideration of the value of the leased
fee estate.
Appraisers should not assume that the sum of the values of the two partial interests equals the value of
the fee simple as this is often not the case. In some instances, the sum of the values of the partial interests
may equal the value of the fee simple, but each partial interest represents a different ownership interest
that must be valued on its own merit (i.e., the present value of the future benefits of each partial interest).
This comparison is particularly important when contract benefits or detriments are substantial. Detrimental
aspects of a lease may result in a situation in which either or both of the parties to the lease, and their cor-
responding value positions, may be diminished.
It is possible that in some cases both the leaseholder and the leased fee owner are at an advantage or
disadvantage because of the terms of the lease. In other cases, there may be an apparent advantage of one
party over the other when compared with other leases. For example, tenants who signed leases when rent
rates were high may be at a disadvantage and pay more than the current market rent if the economy is now
poor and market rates have fallen.
Like all contracts, a real estate lease depends on the actual performance of all parties to the contract. A
weak tenant with the best of intentions may still be a high risk to the lessor. The same is true of a financially
capable tenant who is litigious and willing to ignore lease terms, break a lease, and defy lawsuits. If the ten-
ant defaults or does not renew a lease, the value of the leased fee may be seriously affected.
Because a leasehold or a leased fee interest is based on contract rights, appraisers differentiate between
lease provisions that are generally representative of the market and other elements of a contract that are not
typical of the market. An understanding of the risks associated with the parties to the lease and the lease ar-
rangement is also required. A lease never increases the market value of real property rights to the fee simple.
Any potential value increment in excess of a fee simple estate is attributable to the particular lease contract, and
even though the rights may legally “run with the land,” they constitute contract rather than real property rights.
The Income Capitalization Approach 415

Income capitalization techniques include direct capitalization and yield capital-
ization. In direct capitalization, changes in future property value are implicit in the
rates exhibited by actual market transactions. Yield capitalization anticipates changes
in property income and value over a holding period. Changes in the property’s in-
come stream or future value are reflected by specific inputs.
Definitions
The income capitalization approach employs more specialized terminology than any
of the other approaches to value, and the meanings of the various terms sometimes
overlap. Table 23.1 shows the relationships between different rates used in the ap-
proach and the real property interests that can be valued. Table 23.2 lists synonymous
terms and symbols commonly used in income capitalization.
Table 23.1 Rates, Ratios, and Relationships

Net Income or
Property Interest Cash Flow Forecast Reversion Capitalization Rate Yield Rate
Total property (VO) Net operating Proceeds of resale Overall capitalization Risk rate, discount rate
income (NOI or IO) (PR or VN), property rate (RO) (YO)
reversion
Mortgage loan (VM) Debt service (IM), Balance, balloon, Mortgage capitalization Yield rate to mortgage
monthly—DS, book value (b) rate (RM) (YM), interest rate
annual—ADS
Equity (VE) Equity income (IE) Equity reversion (ER) Equity capitalization Equity yield rate (YE)
rate (RE)
Land (VL) NOI to land (NOIL or IL) Land reversion (LR) Land capitalization Land yield rate (YL)
rate (RL)
Building, NOI to building Building reversion Building capitalization Building yield rate
improvements (VB) (NOIB or IB) (BR) rate (RB) (YB)
Leased fee (VLF) NOI to lessor Property reversion Leased fee capitalization Leased fee yield rate
(NOILF or ILF) (PR or VN) or rate (RLF) (YLF)
proceeds of resale
Leasehold (VLH) NOI to lessee None or proceeds of Leasehold capitalization Leasehold yield rate
(NOILH or ILH) resale of leasehold rate (RLH) (YLH)
estate
Market Value and Investment Value

An important distinction is made between market value and investment value. Investment value is the value
of a property to a particular investor (or class of investors) based on the investor’s specific requirements.
Investment value may coincide with market value, which was defined in Chapter 6, if the client’s investment
criteria are typical of buyers in the market. In this case, the two opinions of value may be the same number,
but the two types of value and their concepts are not interchangeable.
To develop an opinion of market value with the income capitalization approach, an appraiser must be cer-
tain that all the data and forecasts used are market-oriented and reflect the motivations of a typical investor
who would be willing to purchase the property as of the effective date of the appraisal. A particular investor
may be willing to pay a price different from market value, if necessary, to acquire a property that satisfies
other investment objectives unique to that investor.

Table 23.2 Terms and Synonyms Used in the Income Capitalization Approach
Category Term Synonym/Symbol
Lease Flat rental lease Level payment lease
Variable rental lease Index lease
Step-up or step-down lease Graduated rental lease
Revaluation lease
Lease with an annual increase
Percentage lease
Net lease
Triple net lease
Absolute net lease
Rent Market rent
Contract rent
Scheduled rent
Pro forma rent
Effective rent
Excess rent
Deficit rent
Base rent
Percentage rent
Overage rent
Future benefits Potential gross income PGI
Effective gross income EGI
Net operating income NOI or IO*
Equity income Income to equity, IE
Reversion Reversionary benefits, resale value, property reversion, VN
Operating expenses (OE) Fixed expense
Variable expense
Replacement allowance Replacement reserve
Rates of return Overall capitalization rate RO
Equity capitalization rate Cash flow rate, cash-on-cash return, cash throw-off
rate, pretax capitalization rate, equity dividend rate, RE
Terminal capitalization rate Residual capitalization rate, exit capitalization rate, RN
Land capitalization rate Land rate, RL
Building capitalization rate Building rate, RB
Discount rate Yield rate, risk rate
Safe rate Riskless rate, relatively riskless rate
Internal rate of return IRR
Overall yield rate Property yield rate, YO
Equity yield rate YE
Mortgage capitalization rate Mortgage constant, annual loan constant, RM
Going-in capitalization rate
Income multipliers Potential gross income multiplier PGIM
Effective gross income multiplier EGIM
Net income multiplier NIM
Vacancy Vacancy and collection loss
Stabilization Stabilized occupancy
Stabilized income
* The traditional abbreviation NOI is commonly used in accounting, finance, economics, and other professional disciplines. The symbol IO is used in
Appraisal Institute educational materials to maintain a consistent set of variables and subscripts throughout income capitalization calculations.
The terms can be used interchangeably.

Leases
The income to various interests transferred by the landlord to the tenant is generally
derived through the conveyance and operation of a lease. A lease is a written contract
in which the rights to use and occupy land, space, structures, or combinations thereof
are transferred by the owner to another for a specified period of time in return for a
specified rent.2 An appraiser begins the income capitalization approach by analyzing
existing and proposed leases that apply to the subject property. These leases provide
information on the base rent, any other income, and the division of expenses between
the landlord and the tenant.
Although a lease can be drawn to fit any situation, most leases3 fall into one of
several broad classifications for calculating rent:
• Flat rental leases
• Variable rental leases
• Step-up or step-down leases
• Revaluation leases
• Annual increase leases
• Percentage leases
Leases and Expenses

The terms gross lease, modified gross lease, and net lease do not always mean the same thing in different
markets. The terms reflect the expenses that are included in each type of rent, and their meanings vary from
market to market. In general, the following distinctions can be made:
• Gross lease—tenant pays rent and landlord pays expenses.
• Modified gross lease—tenant and landlord share expenses.
• Net lease—landlord passes on all expenses to tenant.
Sometimes real estate professionals will refer to a triple net lease, in which the tenant pays utilities, taxes,
insurance, and maintenance and the landlord pays for structural repairs only.
To analyze income and expenses based on market observation, an appraiser must understand how these
terms are used in the relevant market and clearly communicate that information to the intended user in the
appraisal report. Furthermore, the appraiser must consistently account for the same expenses in the analysis of
the income generated by a certain type of lease. For example, assume the available market data for five com-
parable office properties supports an estimate of market rent in the range of $27.50 to $31.00 per square foot
per year, all quoted on a “net” rental basis. The rents for four of the properties range from $27.50 to $29.00 per
square foot, and the tenants in those buildings pay for all expenses. The owner of the fifth comparable property,
for which “net” rents are quoted at $31.00 per square foot, actually pays for insurance—i.e., that owner defines
“net” rent differently than the other property owners. Consequently, the rent specified in the “net” lease of the
fifth property, which would be equivalent to a “modified” lease in the other buildings, is noticeably higher.
An extreme form of net lease is sometimes referred to as a bondable lease (or sometimes as an absolute
net lease or a type of triple net lease). In this type of lease, the tenant is responsible for all expenses and
structural repairs for the entire duration of the lease term and is even obligated to continue to pay rent after
a casualty or condemnation. The shifting of risk from landlord to tenant creates a lease with the obligations
similar to a bond. Bondable leases are most often used in credit tenant leases.
2. Most states require a written lease only when the term is greater than one year. According to the statute of frauds, which applies in most states,
any contract may be valid but certain contracts must made in writing in order to be enforced by the courts.
3. Other lease types are defined in accounting practice, e.g., capital or financing leases and operating or service leases. These leases often involve equipment.

Generally, leases are negotiated on a gross rental basis (with the lessor paying most
or all operating expenses of the real estate), on a net rental basis (with the tenant paying
all expenses), or on a modified gross rental basis (in which expenses are divided between
the lessor and the lessee.) Leases can also be categorized by their terms of occupancy:
• Month-to-month (renews automatically until properly terminated)
• Short-term (of, for example, five years or less)
• Long-term (of more than five years)
Flat Rental Lease

A flat rental lease specifies a level of rent that continues throughout the duration of the
lease. In a stable market, this type of lease may be typical and acceptable. Flat rental
leases may also be prevalent in net rent situations where changes in expenses are the
responsibility of the tenant (or tenants). In a rising market, however, lessors would pre-
fer long-term leases that are more responsive to changing market conditions, whereas
in that situation lessees would prefer a flat rental lease. Similarly, lessors would prefer
flat leases when rents are falling. When flat rental leases are executed in inflationary pe-
riods, they tend to be short-term such as is typical with apartment leases. Flat leases do
not allow for the increasing costs of the landlord unless there is a provision for expense
pass-throughs. Some valuation assignments for the federal government require apprais-
ers to express the estimate of market rent on a “leveled” basis. This requires forecasting
any change in market rent over a projection period and converting the total income
generated by that lease over the projection period into an annual level equivalent.
Variable Rental Lease

Variable rental leases are quite common, particularly when an owner anticipates pe-
riodic changes in market rent. This type of lease may specify a periodic monetary in-
crease or periodic percentage change, or the change may be tied into a specific index,
such as a nationally published consumer price index. (Often those leases are called
index leases.) Sometimes the lease may specify that the rent change will be tied to the
higher or lower of the two—the periodic percentage or the index. This is particularly
prevalent in gross and modified gross leases where an owner needs periodic income
adjustments to offset increases in expenses.
Step-up or Step-down Rental Lease

Step-up or step-down leases (also known as graduated rental leases) provide for specified
changes in the amount of rent at one or more points during the lease term or in certain
build-to-suit arrangements. A step-up lease, which allows for smaller rent payments in
the early years, can be advantageous to a tenant establishing a business in a new location.
This type of lease can also be used to recognize tenant expenditures on a property that
are effectively amortized during the early years of the lease. Long-term ground leases
may include provisions for increasing the rent to reflect the expectation of future increas-
es in property value and protect the purchasing power of the landlord’s investment.
Step-down leases are less common than step-up leases. They are generally used
to reflect unusual circumstances associated with a particular property such as the
likelihood of reduced tenant appeal in the future or capital recapture of landlord-
funded improvements during the early years of a long-term lease. They may be used
in certain build-to-suit arrangements.

Lease With an Annual Increase
One of the most common types of leases simply increases the rent annually by a dol-
lar amount or set percentage specified in the lease.
Revaluation Lease
Revaluation leases provide for periodic rent adjustments based on revaluation of the
rental rate of the space, land, or structures under the prevailing market conditions. The
revaluation of the rent rate may involve a stated percentage applied to a determined
market value, which may or may not result in market rent. Or the revaluation process
may call for a valuation of the market rent. The terms of the lease must be read carefully
because the valuations may be based on (a) the property’s highest and best use, (b) the
current use, or (c) some other basis. Although revaluation leases tend to be long-term,
some are short-term with renewal option rents based on revaluation of market rent when
the option is exercised. When the parties to a lease cannot agree on the value or rent,
revaluation through appraisal, arbitration, or mediation may be stipulated in the lease.
Percentage Lease
In percentage leases, some or all of the gross income is based on a specified percent-
age of the volume of business or sales, productivity, or use achieved by the tenant.
Percentage leases may be short- or long-term. A straight percentage lease may have
no minimum rent, but most specify a guaranteed minimum rent and an overage rent,
which is defined in the next section. Percentage leases are commonly used for retail
and restaurant space.
Rent
The income to investment properties consists primarily of rent. Different types of rent
affect the quality of property income. Several categories are used by appraisers to
analyze rental income:
• Market rent
• Contract rent
• Effective rent
• Excess rent
• Deficit rent
• Base rent
• Percentage rent
• Overage rent
Market Rent
Market rent is the rental income a property would have commanded had it been
exposed to the market prior to the date of appraisal.4 It is indicated by the current
rents that are either paid or asked for comparable space with the same treatment
of expenses as of the date of value. Market rents vary with economic conditions, so
estimating market rent is not always simple.
4. Market rent is sometimes referred to as economic rent. However, the term economic rent has been used in various ways other than as a synonym
for market rent. For example, in the broader field of economics, economic rent means an excess payment made to a unit of production above and
beyond what is necessary to bring that unit into production. Also, economic rent may be used to mean contract rent derived from a negotiated
rate of return applied to development cost for a build-to-suit property, which may or may not be equivalent to market rent.

In more formal terms, the term market rent is defined as follows:
The most probable rent that a property should bring in a competitive and open market under all
conditions requisite to a fair lease transaction, the lessee and lessor each acting prudently and
knowledgeably, and assuming the rent is not affected by undue stimulus. Implicit in this defini-
tion is the execution of a lease as of a specified date under conditions whereby:
• Lessee and lessor are typically motivated;
• Both parties are well informed or well advised, and acting in what they consider their best
interests;
• Payment is made in terms of cash or in terms of financial arrangements comparable thereto; and
• The rent reflects specified terms and conditions, such as permitted uses, use restrictions,
expense obligations, duration, concessions, rental adjustments and revaluations, renewal and
purchase options, and tenant improvements (TIs).
Rent for vacant or owner-occupied space is usually estimated at market rent

levels and distinguished from contract rent in the income analysis. In fee simple
valuations, all rentable space is estimated at market rent levels and market terms. In
such valuations, adjustments may be necessary to account for lease-up costs and the
time involved in a lease-up. Any rent attributed to specific leases is disregarded in
the income analysis except to the extent that these leases may be indicative of market
rent. In a leased fee analysis, current contract rents defined by any existing leases are
applied to leased space, structures, or land, and income for unoccupied space, struc-
tures, or land is estimated at market rent. When estimating market rent and expenses,
appraisers should assume that property management is competent.
Market data provides evidence of a range of market rents. For example, if the
market for industrial space shows a rent range of $4.00 to $5.00 per square foot of
gross building area per year on a gross rental basis and the subject property is leased
for $3.00 per square foot of gross building area, an appraiser could conclude that the
actual rent is below market levels. However, if the actual subject rents were $4.00,
$4.50, or $5.00 per square foot of gross building area, it may be reasonable to con-
clude that those rents are consistent with market rents. If market rents are on a gross
rental basis and the subject is leased on a net rental basis, it is inappropriate to com-
pare market and contract rent unless adjustments are made to account for differences
in the responsibility for expenses. Moreover, the rents charged for the subject and
comparable space cannot be effectively compared without considering the size and
other physical characteristics of the demised spaces in the properties.
Market rent may be applied as the primary focus of an appraisal intended for the
development of an opinion of market rent or as part of a more in-depth appraisal in
developing an opinion of market value for a property
Contract Rent
Contract rent is the actual rental income specified in a lease. It is the rent agreed on
by the landlord and the tenant and may be higher than, less than, or equal to market
rent. Also, it is important to compare rents of properties with a similar treatment of
expenses, similar lease terms, and a similar level of finished space.
Effective Rent
In markets where concessions take the form of free rent, above-market tenant im-
provements, or atypical allowances, the effective rent must be quantified. Effec-
tive rent is an analytical tool used to compare leases with different provisions and

develop an estimate of market rent. Effective rent may be defined as the total base
rent, or minimum rent stipulated in a lease, over the specified lease term minus rent
concessions—e.g., free rent, excessive tenant improvements, moving allowances,
lease buyouts, cash allowances, and other leasing incentives.
Effective rent may be calculated in several different ways. It may be estimated
based on rental income from existing leases at contract rates and terms or rental
income from leases at market rates and terms, depending on the intended use of the
appraisal. In calculating effective rent, allowances must be made for rent concessions
in effect at the time of the appraisal, any discounts, or other benefits that may have
prompted a prospective tenant to enter into a lease.
The timing of the rent concessions may make analysis of effective rent a moot
point. For example, consider a 10,000-sq.-ft. industrial property with a five-year lease
at $4,000 per month, four months of rent concessions (the first two months of each of
the first two years), and a date of value at the beginning of the third year of the lease.
The concessions granted in the first two years of the lease are not an issue in the
analysis of the income generated in the third year, and the actual and effective rent
would be the same on the date of value.
Effective rent can be calculated as (1) the average, annual rent net of rent concessions,
(2) as the same average, annual rent but with tenant improvements amortized over the
lease term, or (3) as an annual rent that produces the same present value as the actual
annual rents net of rent concessions. The first method is a mathematical average, whereas
the last is a discounting procedure in which the rent concessions are accounted for in the
years that they actually occur. The second method combines the analytical techniques of
the other two. Any of the multiple techniques available are appropriate as long as the ef-
fective rent is applied in a manner consistent with how the effective rent was calculated.
As a simple example of effective rent calculations, consider a lease on another
10,000-sq.-ft. industrial building in which the rent is specified as $4,000 per month (or
$48,000 per year) for a five-year term with level income throughout the lease term.
When the lease was negotiated, the tenant received free rent for the first month of
each year as a concession. The contract rent is $4.80 per square foot. However, the ef-
fective rent is only $4.40 per square foot:
$4,000 per month × 11 months = $44,000
$44,000 / 10,000 square feet = $4.40 per square foot
There are different ways to treat tenant improvement costs. The appraisal problem
will dictate whether it is appropriate to deduct all tenant improvements or only de-
duct the additional actual tenant improvement costs over a market standard.
Excess Rent and Deficit Rent

Excess rent is the amount by which contract rent exceeds market rent at the time of the
appraisal. Excess rent is created by a lease that is favorable to the lessor and may reflect
superior management, a lease that was negotiated in a stronger rental market, a lease
that was a build-to-suit or sale-leaseback at above market rents, or a lease in which the
rent also included a return on fixtures or personal property. Excess rent may be ex-
pected to continue for the remainder of the lease (if the relationship of contract rent and
market rent is expected to remain the same for the duration of the lease). However, due
to the higher risk associated with the receipt of excess rent, it may be calculated sepa-
rately and capitalized or discounted at a higher rate. Excess rent is the result of a lease

contract rather than the income potential of the underlying real property on the valua-
tion date. The incremental value created by a lease premium can result in a leased fee
value that exceeds the fee simple. The situation where contract rent and terms exceed
market rent and terms is known as a negative leasehold.
Tenants of a local nature paying excess rent may have their businesses fail
because of the rental disadvantage and possibly compel the landlord to renegotiate
a lower rent. Higher risk may also be attributable to the excess rent paid by a finan-
cially capable company with the power to contest the lease.
Deficit rent is the amount by which market rent exceeds contract rent at the time
of the appraisal. It is created by a lease favorable to the tenant and may reflect unin-
formed or unusually motivated parties, inferior management, or a lease executed in a
weaker rental market. When contract rent is less than market rent, a positive lease-
hold interest accrues to the tenant. However, the leasehold advantage may be non-
marketable, particularly when the remaining lease term is short, the spread between
contract and market rent is not significant, or a combination of both factors exists. It
may also be unmarketable if the lease prohibits subleasing where any gain could be
monetized. Even so, it would accrue to the tenant in the form of a benefit. When there
is a positive leasehold interest for a financially credible tenant, there is often reduced
risk for the landlord (owner of the leased fee estate). This may reduce the capitaliza-
tion rate or discount rate that is appropriate for the leased fee position.5
Percentage Rent
Percentage rent is rental income received in accordance with the terms of a percentage
rent clause in a lease. Percentage rent is typically derived from retail and restaurant ten-
ants and is based on a certain percentage of their sales revenue. Depending on the ten-
ant, percentage rent may involve more risk than other forms of rent and may be capital-
ized or discounted separately and at a different rate. The risk generally is in the variabil-
ity of the income, more than in the likelihood that rent collection will be difficult.
The emergence of new competition in the area or the anchor tenant departing
from a shopping center may reduce or eliminate anticipated percentage rent. Also, as
is true for excess rent, the conditions that create percentage rent may not extend for
the duration of the lease. Furthermore, calculation of a store’s sales revenue can be
affected by transactions involving a “virtual” or internet component.
Overage Rent
Overage rent is percentage rent paid over and above the guaranteed minimum rent
or base rent. The level of sales at which a percentage clause is activated is specified in
a lease and called a breakpoint. The natural breakpoint is the level of sales at which the
percentage rent exactly equals the base rent.
The breakpoint in a percentage lease does not necessarily have to be the natural
breakpoint. For example, if the annual base rent is set in the lease at $400,000 and the
percentage of retail sales specified in the lease is 20%, then the natural breakpoint for
sales volume is $2 million—i.e., $400,000 / 0.20 = $2 million. The breakpoint speci-
fied in the lease could be set at a sales volume of $2.25 million. In this case, the tenant
would pay the base rent of $400,000 until sales reached $2.25 million and the percent-
5. See Richard L. Parli and Jeffrey D. Fisher, “Risk and Reasonableness for Nonmarket Occupancy,” The Appraisal Journal (April 2003): 136-144,
and “Risk and Reasonableness for Nonmarket Occupancy—A Second Look During a Recession,” The Appraisal Journal (Winter 2010): 94-103.

age rent clause would be activated so that the rent jumps to $450,000 ($2,250,000 × 0.20
= $450,000). The breakpoint could also be set lower than the natural breakpoint—say,
at a sales volume of $1.75 million—but the actual rent paid will be higher than the base
rent if overage rent is earned. That is, the tenant would pay the base rent of $400,000
until sales reached the natural breakpoint of $2 million, at which point the percentage
rent attributed to overage rent would start to rise above the level of the base rent.
Overage rent should not be confused with excess rent. The combination of base
rent and overage rent may be market rent, less than market rent, or more than market
rent. In the latter case, there would be excess rent.
Future Benefits
The benefits of owning specific rights in income-producing real estate include the
right to receive all cash flows accruing to the real property over the holding or projec-
tion period (i.e., the term of ownership) plus any proceeds from disposition of the
property at the termination of the investment.6 While actual disposition might not oc-
cur, it is presumed in order to quantify the reversion, just as market value presumes a
sale as of the effective date of value.
Various measures of future benefits are considered in the income capitalization
approach. Commonly used measures include
• Potential gross income
• Effective gross income
• Net operating income
• Equity income
• Reversionary benefits
Potential Gross Income

Potential gross income (PGI) is the total potential income attributable to the real
property at full occupancy before vacancy and operating expenses are deducted. It
may refer to the level of rental income prevailing as of the effective date of the ap-
praisal or expected during the first full month or year of operation, or to the periodic
income anticipated during the projection period.
Effective Gross Income

Effective gross income (EGI) is the anticipated rental income and other income from
the real property adjusted for vacancy and collection losses. This adjustment covers
losses expected to be incurred due to unoccupied space, turnover, and nonpayment
of rent by tenants.
Net Operating Income

Net operating income (NOI or IO) is the actual or anticipated net income remaining af-
ter all operating expenses are deducted from effective gross income. Net operating in-
come is customarily expressed as an annual amount. In certain income capitalization
applications, a single year’s net operating income may represent a steady stream of
fixed income that is expected to continue for a number of years. In other applications,
the income may represent the starting level of income that is expected to change in
6. The holding period is a market-oriented measure of how long investors typically retain ownership of real property. The projection period is used
in investment analysis to forecast the term of ownership given the reasonable expectations of certain market events.

a regular or irregular pattern over time. Still other applications may require that net
operating income be estimated for each income period of the analysis. Net operating
income is often calculated after a deduction is made for replacement reserves but, in
some markets, reserves are deducted after the calculation of net operating income.
Equity Income
Equity income (IE) is the portion of net operating income that remains after debt ser-
vice is paid. Like net operating income, a single year’s equity income may represent
a steady stream of fixed income, the starting level of a changing income stream, or
the equity income for a particular period of the analysis. Equity income is sometimes
called equity cash flow, equity dividend, cash throw-off, pre-tax cash flow, or cash on cash.
Reversion
Reversion is a lump-sum benefit an investor receives, or expects to receive, upon
termination of an investment or at an intermediate analysis period during the term of
an investment. The reversionary benefit may be calculated before or after the mort-
gage balance is deducted. For example, the reversionary benefits for fee simple and
leased fee estates are the net proceeds expected to result from resale of the property
at the end of the investment projection period. For a mortgagee or lender, reversion
consists of the balance of the mortgage when it is paid off or forecast to be paid off.
Table 23.3 shows several possible investment positions in an income-producing prop-
erty and identifies the income streams and reversions associated with each interest.
Reversionary benefits are usually estimated as anticipated dollar amounts or as
relative changes in value over the selected projection period. A dollar estimate of the
reversion might be based on a lessee’s option to purchase the property at the end of
the lease. Alternatively, the value of the reversion at the end of the projection pe-
riod might be estimated by applying a capitalization rate to the income that a buyer
expects to receive at the time of resale (or expected resale). Reversionary benefits may
or may not require separate measurement, depending on the purpose of the analy-
sis and the method of capitalization used. The reversionary benefits derived from
Table 23.3 Summary of Incomes and Reversions Associated with Various Real Property
Interests in Income-Producing Property
Fee Simple
Income Net operating income based on market rents (NOI or IO) (may require adjustment for lease-up)
Reversion Net proceeds of disposition (VN)
Mortgagee (Lender’s Position)
Income Mortgage debt service (IM)
Reversion Balance if paid prior to maturity or balloon payment if paid at maturity; none if loan amortizes fully (VMN)
Leased Fee
Income Net operating income based on contract rents for leased space and market rent for vacant space (may
require adjustment for lease-up)
Reversion Property reversion or net proceeds of disposition of leased fee estate
Leasehold
Income Rental advantage when contract rent is below market rent; rental disadvantage when contract rent is
above market rent
Reversion None or proceeds of resale of leasehold estate

an investment may be particularly uncertain in depressed markets, but a reversion
amount is still a consideration.
Operating Expenses
In the income capitalization approach, a comprehensive analysis of the annual expenses
of property operation is essential, whether the value indication is derived from estimat-
ed net operating income or equity income. Operating expenses are the periodic expen-
ditures necessary to maintain the real property and continue the production of revenue.
An operating statement that conforms to this definition of operating expenses is used
for appraisal purposes. This reconstructed operating statement may differ from state-
ments prepared for an owner or by an accountant because the latter often include mort-
gage interest or non-cash expenses such as depreciation. Operating statements are pre-
pared on either a cash or accrual basis, and appraisers must know the accounting basis
used in the operating statements for the property being appraised. Operating statements
provide valuable factual data and can be used to identify trends in operating expenses.
Operating expenses comprise three categories:
• Fixed expenses
• Variable expenses
• Replacement allowance
These classifications have been used for a long time, but there are other valid clas-
sification systems that can be employed, and different property types may require
different classifications.
Fixed Expenses
Fixed expenses are operating expenses that generally do not vary with occupancy
and have to be paid whether the property is occupied or vacant. Real estate taxes and
building insurance costs are typically considered fixed expenses. Although these ex-
penses rarely remain constant, they generally do not fluctuate widely over the short
term from year to year, do not vary in response to changing occupancy levels over
the short term, and are not subject to management control. Therefore, an appraiser
can usually identify a trend and accurately estimate these expense items.
Variable Expenses
Variable expenses are operating expenses for utilities, maintenance, janitorial, and
other services that generally vary with the level of occupancy or the extent of services
provided, though most variable expenses have some minimal fixed component re-
gardless of occupancy. Specific expense items of this type may vary greatly from year
to year, but similar types of property often reflect a reasonably consistent pattern of
variable expenses in relation to gross income. Because fewer services are provided to
the tenants of freestanding retail and industrial properties or unenclosed structures
or buildings, these properties usually have a much lower ratio of expenses to gross
income than apartment and office buildings.
Replacement Allowance
A replacement allowance provides for the periodic replacement of building compo-
nents that wear out more rapidly than the building itself and must be replaced peri-
odically during the building’s useful life (i.e., capital items). Market participants may

view replacement allowances differently from market to
market—e.g., accounting for a replacement allowance as An investor’s total expected
return includes the return of
a line item or implicitly in the capitalization or discount capital (recapture of capital)
rate. Appraisers must deal with replacement allowances and a return on capital
in a manner that is consistent with the method used in (compensation for use of
the relevant market for comparable properties and the capital until recapture).
manner in which the capitalization or discount rate was Rates of return may be in-
come rates (ratios of annual
extracted from market data. income to value that are
used to convert income into
Rates of Return value) or yield rates (rates of
A prudent investor ultimately seeks a total return great- return on capital).
er than or equal to the amount invested. Therefore, the
investor’s expected return consists of two components:
• Full recovery of the amount invested, i.e., the re-
turn of capital
• A reward for the assumption of risk, i.e., a return on invested capital
Because the returns from real estate may take a variety of forms, many rates, or
measures of return, are used in capitalization. All measures of return can be catego-
rized as either
• income rates, such as an overall capitalization rate (RO) or equity capitalization
rate (RE), or
• yield rates, such as an effective interest rate (the rate of return on debt capital),
discount rate (the rate used to convert future cash flows into present value, YO),
or internal rate of return (IRR).
The term discount rate describes any rate used to convert future cash flows over
time into a present value. Because investors expect their total return to exceed the
amount invested, the present value of a prospective benefit is less than the total in-
come over the ownership term—thus the “discount.”7 A yield rate is the rate of return
on capital. The discount rate is a pure rate of return on the investment and the return
of the investment is in the cash flows themselves.
Under certain conditions, the yield rate (YO) for a property may be numerically
equivalent to the corresponding income rate (RO) in a zero-growth discounted cash
flow analysis. Nevertheless, the rates and their related concepts are not the same, nor
are they interchangeable. An income rate is the ratio of one year’s income to value.8 A
discount rate is applied to a series of individual cash flows to obtain the present value.
In the income capitalization approach, both income rates and yield rates can be
derived for, and applied to, any component of real property rights or the underlying
physical real estate. For example, an appraiser may analyze total property income in
terms of income to the mortgage and equity interests in the property. Similarly, an
appraiser may seek the total investment yield or analyze the separate yields to the
mortgage and the equity interests. Finally, an appraiser may want to analyze the val-
ue of the unencumbered fee simple, the leased fee, or the leasehold interest. (Practical
7. For a thorough discussion of discounting, see Charles B. Akerson and David C. Lennhoff, editor, Capitalization Theory and Techniques: Study Guide,
3rd ed. (Chicago: Appraisal Institute, 2009).
8. The rate is usually calculated with the income for the first year, although the income for the previous year may be used. In rare cases, the incomes
for several years might be averaged to obtain a representative income figure.

examples of these applications and the relevant symbols, formulas, and procedures
are presented in Chapter 28.)
Return on and Return of Capital

The notion that an investor anticipates a complete recovery of invested capital—plus a
payment for the use of capital—prevails in the real estate market just as it does in other
markets. The term return of capital refers to the recovery of invested capital. The term re-
turn on capital refers to the additional amount received as compensation for use of the in-
vestor’s capital until it is recaptured. Investors are concerned with both types of return.
The rate of return on capital is analogous to the yield rate or the interest rate earned or
expected. A typical example is the mortgage loan calculation in which the return of and
the return on capital are considered in the level mortgage payment over time.
In real estate investments, capital may be recap-
tured in many ways.9 Investment capital may be recap-
return of capital tured through periodic income, or it may be recaptured
The recovery of invested all or in part through disposition of the property at the
capital through periodic termination of the investment. It may also be recap-
income or reversion or both.
tured through a combination of both. If the property
return on capital
value does not change between the time the initial
The additional amount
received as compensation investment is made and the time the property is sold,
(profit or reward) for use of the investor can recapture all the initial capital invested
an investor’s capital until it is at property resale at the end of the holding period.
recaptured. The rate of return Thus, when initial value is equivalent to resale value,
on capital is the yield rate or the annual income can all be attributed to the return on
the interest rate earned or
expected. capital. If the income has remained level (or constant),
the indicated income rate (i.e., the overall capitalization
rate) will equal the return on capital.
In yield capitalization the distinction between the
return on and the return of capital is more explicit. The yield rate estimated for cash
flows determines a specified return on capital. Direct capitalization, on the other
hand, uses income rates such as overall capitalization rates, which must implicitly
allow for both the return on and return of capital. When the capitalization rate is ap-
plied to the subject property’s income, the indicated value must represent a price that
would allow the investor to earn a market rate of return on the capital invested along
with the recapture of the capital. Thus, the capitalization rate estimated and applied
to value property must reflect or consider a market level of return of and return on
the initial investment in one calculation.
Income Rates
An income rate expresses the relationship between one year’s income and the
corresponding capital value of a property. An overall capitalization rate (RO) is an income
rate for a total property that reflects the relationship between a single year’s net operating
income and the total property price or value. It is used to convert net operating income
into an indication of overall property value. An overall capitalization rate is a ratio
between the first year’s income and the value. It includes both the return of and return
9. The term recapture was coined at a time when investors assumed that property values could only decline due to depreciation from physical or
functional causes. Today appraisers use the term when some income provision must be made to compensate for the loss of invested capital.

on capital with consideration of the percieved risk and anticipation of future income or
value changes by the investor. It may be more than, less than, or equal to the expected
yield on the capital invested, depending on projected income and value changes.
An equity capitalization rate (RE) is an income rate that reflects the relationship
between a single year’s equity income expectancy and the equity investment. When
used to capitalize the subject property’s cash flow after debt service into equity value,
the equity capitalization rate is often referred to in the real estate market as the cash
flow rate, cash-on-cash rate, cash-on-cash return, or equity dividend rate. Like the overall
capitalization rate, the equity capitalization rate may be more than, less than, or equal
to the expected equity yield rate, depending on projected changes in income, value,
and amortization of the loan.
Discount Rates
Different discount rates are used to discount cash flows applicable to a specific position
or interest in defined real estate. Discount rates are different from capitalization rates.
With a discount rate, any anticipated changes in income or value are explicit in the cash
flows. With capitalization rates, the changes are implicitly accounted for in the rate.
A yield rate is a rate of return on capital. It is usually expressed as a compound
annual percentage rate. The yield rate considers all expected property benefits (both
positive and negative over time), including the proceeds from disposition at the
termination of the investment, if any. The term interest rate usually refers to the yield
rate for debt capital, not equity capital.
An internal rate of return (IRR) is the yield rate that is earned for a given capital
investment over the period of ownership. The internal rate of return for an invest-
ment is the yield rate that equates the present value of the future benefits of the
investment to the amount of capital invested. The internal rate of return applies to
all expected benefits, including all periodic cash flows and the net proceeds from
disposition at the investment’s termination. It can be used to measure the return on
any capital investment, before or after income taxes.
An overall yield rate (YO), or property yield rate, is a rate of return on the total capital
invested. It considers all changes in income over the investment projection period as well
as the reversion at the end of the projection period. It does not, however, consider the
effect of debt financing. Rather, it is calculated as if the property were purchased with no
debt capital and thus is sometimes called an unleveraged rate or an unlevered rate. The over-
all yield rate can be viewed as the combined yield on both the debt and equity capital.
An equity yield rate (YE) is a rate of return on equity capital. It may be distin-
guished from a rate of return on debt capital, which is usually referred to as an effec-
tive mortgage interest rate or mortgage yield rate (YM). The equity yield rate is the equity
investor’s internal rate of return. It is affected by the amount of financial leverage em-
ployed in securing mortgage debt and thus is known as a leveraged rate or levered rate.
Estimating Rates
Whether an income rate or a yield rate is applied, the conversion of income into
property value should reflect the annual rate of return the market indicates is neces-
sary to attract investment capital. This rate is influenced by many factors:
• The degree of perceived risk
• Market expectations regarding future inflation

• The prospective rates of return for alternative invest-
The rate of return on investments (i.e., opportunity costs)
ment combines a safe rate
with a premium to compen- • The rates of return earned by comparable properties
sate the investor for risk, the in the past
illiquidity of invested capital, • The availability of debt financing
and management involve-
ment. The rate of return on • The prevailing tax law
capital may incorporate Because the rates of return used in the income capitaliza-
inflationary expectations and
should reflect the competition approach represent prospective rates, not historical
tion for capital among rates, the market’s perception of risk and changes in
alternative investments of purchasing power are particularly important. Generally,
comparable risk. lower capitalization rates are associated with properties
that have different characteristics—higher-quality ten-
ants, lower perceived risk, greater potential for increases
in income and value, and broader market appeal—than
time value of money
properties that have higher capitalization rates. General
The concept underlying
market conditions, prevailing interest rates, and the
compound interest that
holds that economic benefits availability of equity and debt capital are a few of the fac-
received today are worth tors that cause changes in capitalization rates over time.
more than economic benefits The suitability of a particular rate of return cannot
received in the future due to be proven with market evidence, but the rate estimated
opportunity cost, inflation,
should be consistent with the data available. Estimat-
and the certainty of payment.
ing rates requires appraisal judgment and knowledge
of prevailing market attitudes and economic indicators.
Typically, investors expect to receive a return on capi-
tal that represents the time value of money with an appropriate adjustment for perceived
risk. The minimum rate of return for invested capital is sometimes referred to as the safe,
riskless, or relatively riskless rate—e.g., the prevailing rate on insured savings accounts or
guaranteed government securities.10 Theoretically, the difference between the total rate
of return on capital and the safe rate may be considered a premium to compensate the
investor for risk, the illiquidity of invested capital, and other investment considerations.
A discount rate reflects the relationship between income and the value that a market
will attribute to that income. The financial and economic concepts implicit in a discount
rate are complex and have been the subject of significant analysis for more than a centu-
ry. Although four key components can be identified within a discount rate—the safe rate
plus considerations of illiquidity, management, and various risks—a discount rate that is
constructed by adding allowances for these components can be inappropriate. The band-
of-investment concept can be helpful in understanding these components, especially
in differentiating marginal risk considerations. While they can be used to approximate
market-extracted rates, they should not be represented as market-extracted rates.
Risk
The anticipation of receiving future economic benefits creates value, but the possibil-
ity of not receiving or losing future benefits reduces value and creates risk. Higher
rewards are required in return for accepting higher risk. To a real estate investor,
10. For example, federal statutes prescribe certain US securities rates as a means of compensating for the time value of money on an essentially risk-free
basis while accounting for inflation. See 40 USC §1961 and the amendment contained in Public Law No. 106-554, effective December 21, 2000.

risk is the uncertainty of realizing projected future economic benefits and the chance
of incurring a financial loss. Most investors try to avoid excessive risk. They prefer
certainty to uncertainty and expect a reward for taking a risk. Appraisers must recog-
nize investors’ attitudes in analyzing market evidence, projecting future benefits, and
applying capitalization procedures. An appraiser must be satisfied that the income
rate or yield rate used in capitalization is consistent with market evidence and re-
flects the level of risk associated with receiving the anticipated economic benefits.
Inflation and Value

Appraisers should be aware of the difference between inflation and appreciation in
real value. Inflation is an increase in the volume of money and credit, a rise in the
general level of prices, and the erosion of purchasing power. Appreciation in real
value results from an excess of demand over supply, which increases property values
beyond the level of inflation.
The amount of inflation expected affects the forecast of future benefits and the
estimation of an appropriate income or yield rate. If inflation is anticipated, the
desired nominal rate of return on invested capital will likely increase to compensate
for lost purchasing power. The required nominal rate, then, will increase to offset the
expected inflation. Most investors try to protect the real rate of return over time.
A distinction must be made between expected inflation and unexpected infla-
tion. Expected inflation refers to changes in price levels that are expected at the time
the investment is made or when the property is being appraised. However, actual
inflation may differ from what was anticipated at the time the investment was made.
Depending on how the investment responds to the actual change in price levels, its
value may fluctuate over time at a different rate than originally anticipated. If the
return on the investment does not increase with unexpected inflation, the investor’s
real rate of return will be less than originally projected.
The converse of inflation—deflation—is a decrease in the general price level of
commodities. In a deflationary period, the purchasing power of money rises be-
cause general price levels are falling. Historically, deflation has not been a significant
problem in the United States since the beginning of World War II. The -0.4% change
in the annual average of the consumer price index in 2009 was only the third year of
negative change in that indicator since the 1930s and the only negative change from
1955 to 2019. Theoretically, deflation should affect the return on an investment in the
opposite manner of inflation. That is, because of expected deflation, the nominal rate
of return on an investment in real property would likely decrease to account for the
greater purchasing power of the cash. In a deflationary period with asset prices fall-
ing, the value of cash in hand may be perceived as greater than the potential appre-
ciation of property, which could decrease investment and lending.
Procedure
The income capitalization approach supports two basic methods: direct capitaliza-
tion, which uses the relationship of one year’s income to conclude a value, and yield
capitalization, which considers a series of cash flows over time together with any
reversion value or resale proceeds.
Both methods require an initial comprehensive study of historical income and
expenses for the subject property. This study is combined with an analysis of typical

income and expense levels for comparable properties. A
The two methods of income reconstructed operating statement is developed for the
capitalization are direct capi-
talization, in which a single subject property. This reconstructed operating state-
year’s income is divided by ment must reflect the intended use of the appraisal,
an income rate or multiplied especially with respect to the property interest being ap-
by an income factor to reach praised. Leased fee value will reflect current leases and
an indication of value, and the associated expense structure, while fee simple value
yield capitalization, in which
future economic benefits starts with an income projection based on market rent.
are converted into a value Yield capitalization will require a consideration
indication by discounting of probable income and expenses over the designated
them at an appropriate yield projection period, which is determined based on obser-
rate (DCF analysis) or apply- vations of typical holding periods for similar property
ing an overall capitalization
rate that reflects the invest- types. When this method is used, an appraiser must
ment’s income pattern, value forecast income and expenses over time together with
change, and yield rate. the eventual reversion or resale value of the property.
Direct capitalization, on the other hand, typically uses
a one-year cash flow estimate (usually 12 months from
the date of value) and application of an overall rate to
estimate value. This method often relies on sales of properties with income character-
istics and future expectations similar to the subject’s, although alternate methods for
developing the appropriate rate are available.
Although there are various income capitalization techniques available to apprais-
ers, certain steps are essential in applying the income capitalization approach. Before
applying most capitalization techniques, an appraiser works down from potential
gross income to net operating income. To do this, the appraiser will
1. Research the income and expense data for the subject property and comparables.
2. Estimate the potential gross income of the property by adding the rental income
and any other potential income.
3. Estimate the vacancy and collection loss.
4. Subtract vacancy and collection loss from total potential gross income to arrive
at the effective gross income of the subject property. (If the potential income is
estimated net of the impact of vacancy, then it must be added after the deduction
for vacancy and collection loss, not before.)
5. Estimate the total operating expenses for the subject by adding fixed expenses,
variable expenses, and a replacement allowance (where applicable).
6. Subtract the estimate of total operating expenses from the estimate of effective
gross income to arrive at net operating income. (Deductions for capital items
may also be necessary at various points in time through the projection period to
calculate the cash flow used in discounted cash flow analysis.)
7. Apply one or more of the direct or yield capitalization techniques to this data to
generate an estimate of value via the income capitalization approach.
8. If necessary, calculate a rent-up adjustment for the value indication that accounts
for the cost of leasing up the property or for needed capital improvements (in-
cluding an appropriate estimate of entrepreneurial incentive).

Some capitalization techniques involve the use of a potential gross income mul-
tiplier or effective gross income multiplier. In those cases, appraisers do not work
down to net operating income but stop at potential or effective gross income.
Direct Capitalization, Yield Capitalization, and Discounting

Direct capitalization makes use of a single year’s income and a market-derived factor
or overall capitalization rate. Initially, the process appears rather simple. The prac-
titioner need only estimate the income and the factor or overall capitalization rate.
In contrast, yield capitalization requires the practitioner to make explicit forecasts of
income, expenses, and changes in vacancy levels and expenses over the projection
period. The net sale price of the property at the end of the projection period must also
be estimated. The concluded yield rate is then applied to convert anticipated eco-
nomic benefits into present value.
Practitioners who use direct capitalization must recognize that, while an overall
capitalization rate is only applied to one characteristic of the property (i.e., to a single
period’s income), the overall capitalization rate is valid only if it accounts for all the
other characteristics of the property.11 For example, suppose that annual increases of
3% are forecast in the net rent of a comparable sale property and an overall capital-
ization rate of 10% for the comparable property is extracted from the market data.
Furthermore, suppose that annual increases of 2% are forecast in the net rent of the
subject property. Applying the overall capitalization rate of 10% extracted from the
sale property to the income stream of the subject property is a misapplication of the
approach and would overstate the subject property’s value.
In yield capitalization, specific conclusions must be drawn about changes in net
income, cash flow, and property value over the projection period. These conclusions
are set forth in forecasts of future income and property reversion.
Also, specific investment goals for the return on and of invested capital can be
considered in yield capitalization. The property’s projected income and reversion
are discounted to a present value by applying the market’s anticipated yield rate
in the present value procedure. Yield rates can be derived (from comparable sales,
interviews, etc.) with formulas and factors obtained from financial tables or calcu-
lated and applied with financial calculators or personal computers. Various software
programs can also be used to discount cash flows.
Both direct capitalization and yield capitalization are market-derived techniques,
and when applied correctly they should result in similar value indications for a sub-
ject property. In applying the income capitalization approach, appraisers do not need
to limit the analysis to a single capitalization method. With adequate information and
proper use, direct and yield capitalization methods should produce similar results.
If differences arise, an appraiser should check that the various techniques have been
applied correctly and consistently and that the analysis reflects the actions of mar-
ket participants. The results derived from the application of different capitalization
techniques should be reconciled within the income capitalization approach and may
be considered again in final reconciliation.
11. See David C. Lennhoff, “Direct Capitalization: It Might Be Simple But It Isn’t That Easy,” The Appraisal Journal (Winter 2011): 66-73.

Income and Expense Analysis 24
To apply any capitalization procedure, a reliable estimate of income expectancy must

be developed. Although an appraiser may consider the actual income of the subject
property at the time of the appraisal, valuation is based on a projection of future
income. Among other things, an appraiser should consider the future outlook both in
estimating income and expenses and in selecting the appropriate capitalization meth-
odology to use. The consideration of future income is consistent with the principle of
anticipation, which holds that value is the present worth of future benefits.
Historical income and current income are significant, but the ultimate concern
is the future. The earning history of a property is important to the degree that as it is
accepted by buyers as an indication of the future, and the prior year’s income should
be analyzed as a good basis for projection and reasons for variance understood and
explained. Current income is a good starting point, but the direction and expected
pattern of income change are critical to the capitalization process.
Many types of first-year income can be converted into value estimates for differ-
ent property interests using direct capitalization. Some examples are
• Net operating income (NOI or IO)
• Equity income (IE)
In yield capitalization, periodic cash flows and appropriate reversion values can
be used to estimate the value of different property interests, including:
• Annual IO and property reversion, when applicable, over a projection period for a
leased fee (VLF), fee simple (VO), or leasehold value (VLH)
• Annual income to equity (IE) and equity reversion over a projection period for an
equity value (VE)
• Property cash flow considering tenant improvements (TIs) and leasing commis-
sions, and property reversion over the projection period for a leased fee or fee
simple value
When applying either direct or yield capitalization, reliable projections of income
are critical to credible assignment results. Significant value differences can result
when the same capitalization rate or potential gross income multiplier is used to
convert different income estimates into value. For example, a gross income multiplier
of 11.0% applied to potential income estimates of $50,000 and $55,000 results in value
estimates of $550,000 and $605,000. A $5,000 difference in potential gross income
produces a $55,000 difference in value. Similarly, applying an overall capitalization
rate of 6.0% to net operating income estimates of $35,000 and $40,000 results in value
estimates of $583,333 and $666,667. In this example, a $5,000 difference in net operat-
ing income results in a $83,334 value difference. Income forecasting is a sensitive and
crucial part of income capitalization because income projections have a significant
effect on value.
An appraiser may estimate income for a single year or series of years depending
on the property type, the data available, and the capitalization method employed.
The analysis can be based on
• A reconstructed income/expense statement
• A forecast of income for the first year of the investment
• Stabilized income for the first year
• A forecast of income over a specified projection period
• A level-equivalent annual income over a specific projection period
If an opinion of market value is sought, the income forecast should reflect the ex-
pectations of market participants, i.e., the space users competing in the fundamental
market. In an assignment to develop an opinion of investment value, an appraiser
may base the income forecasts on the specific ownership or management require-
ments of that market segment.
If a partial interest is being valued, the equity income may be used as the basis of
the analysis. In this case, annual mortgage debt service is deducted from net operating
income to calculate the equity income. Sometimes debt service is based on an existing
mortgage and the amount is specified. In other cases, debt service must be estimated
based on the typical mortgage terms indicated by current market activity and the prop-
erty type being appraised.
Table 24.1 lists the key elements to investigate in developing income and expense
estimates for various property types. The specific line items involved in the genera-
tion of income and the allocation of expenses may vary for different property types.
Estimating Market Rent

An investigation of market rent levels starts with the subject property and the prop-
erty attributes. An appraiser can verify the subject property’s current rent schedule by
examining financial statements, tenant files, and executed and pending leases as well
as interviewing selected tenants during property inspection. Further verification may
be necessary if the owner’s or manager’s information is in doubt or if it is required
based on the scope of work. The sum of current rents may be compared with previous
totals using operating statements for the past several years. Statements of rents, in-
cluding the rent paid under percentage leases or escalation clauses, should be exam-
ined for all building tenants. After analyzing the existing rent schedule for the subject

Table 24.1 Characteristic Income and Expenses of Principal Property Types
Industrial Buildings
Lease and income Medium- to long-term net or modified gross lease.
Expenses Tenants pay most operating expenses and sometimes prorated property taxes, insurance, and
exterior maintenance; landlord pays management expenses; tenant improvement allowance
sometimes provided by landlord; leasing commissions paid by landlord to agent or broker.
Retail Properties
Major (anchor) tenants
Lease and income Long-term net lease; base and percentage (overage) rent.
Expenses Tenants pay utilities, interior maintenance, and common area maintenance (such expense
recoveries are prorated); tenants may share in advertising and management expenses; tenant
improvement allowance provided by landlord; anchor tenant’s common area maintenance and
realty taxes may be subsidized by the non-anchor tenants that benefit from customer traffic
generated by the anchor; leasing commissions paid by landlord to agent or broker; tenant
improvements and leasing commissions are typically treated as below-the-line items (i.e., not
deducted before derivation of net operating income).
Smaller (local) tenants
Lease and income Short- to medium-term net lease; base and percentage (overage) rent.
Expenses Tenants pay utilities, interior maintenance, and common area maintenance (these expense
recoveries are prorated); tenants may share in advertising and management expenses; tenant
improvement allowance provided by landlord; leasing commissions paid by landlord to agent or
broker; tenant improvements and leasing commissions are typically treated as below-the-line
items.
Multifamily Residential Properties
Lease and income Lease for one year or less; modified gross lease.
Expenses Tenants often pay own utility expenses; landlord pays property taxes, insurance, management,
and maintenance; replacement allowance may be treated as an above-the-line item; no tenant
improvement allowance.
Office Buildings
Lease and income Medium- to long-term lease; base rent may be adjusted upward on an escalation basis ac-
cording to an index.
Expenses Under a gross lease, landlord pays all operating expenses; under a net lease, tenants pay all
expenses; leases may contain provisions to pass through any increase in certain expenses over
a specified base amount and customarily on a per-square-foot basis. Tenant improvement al-
lowance provided by landlord; leasing commissions paid by landlord to agent or broker. Both
are treated as below-the-line expenses.
Note: The treatment of expenses described here is typical in many, but not all, markets.
property, an appraiser converts all rents to a unit basis (e.g., per square foot) for
comparison. All differences in rents within the property are described and explained.
Then rental data for comparable space in the market is assembled so that equivalent
market rents can be estimated and reduced to an appropriate unit of comparison.
When a market rent estimate for the subject property is required, comparable rental
data is gathered, compared, and adjusted. The parties to each lease should be identified
to ensure that those held responsible for rent payments are actually parties to the leases
or, by endorsement, the guarantors. It is also important to ascertain that the lease rep-
resents a freely negotiated, arm’s-length transaction. A lease that does not meet these
criteria—such as a lease between related entities (e.g., the landlord and the tenant have
common ownership or common interests)—often does not provide a reliable indication

of market rent. Sale-leaseback transactions must be used with caution because the lease
is usually negotiated as part of the sale rather than as an independent, market-based
lease negotiation. Sale-leasebacks that are negotiated as financing vehicles may reflect
motivations of the tenant and landlord that are not typical of the market.
The rents of comparable properties can provide a basis for estimating market rent
for a subject property once they have been reduced to the same unit basis applied to
the subject property. Comparable rents may be adjusted just as the transaction prices
of comparable properties are adjusted in the sales comparison approach. Recently
executed and pending leases for the subject property may be a good indication of
market rent, but lease renewals or extensions negotiated with existing tenants should
be analyzed with caution. Existing tenants may be willing to pay higher rents to
avoid the cost of relocating. Alternatively, a landlord may offer existing tenants lower
rent to avoid vacancies and the expense of obtaining new tenants.
The elements of comparison considered in rental analysis are
Real property rights being leased Rentals that do not reflect arm’s-length negotiations will generally
and conditions of rental not provide meaningful information as comparables.
Market conditions Economic conditions change, so leases negotiated in the past
may not reflect current prevailing rents
Location Time-distance linkages and unit-specific locations in project
Physical characteristics Size, height, width, depth, interior finish, functional layout,
site amenities, etc.
Division of expenses stipulated in Were concessions made? Who pays operating expenses? What
the lease and other lease terms are the provisions regarding changing the rent during the term
of the lease?
Use of the property Market rents might have to be adjusted for the use or level of
build-out of the subject property when it differs from that of
the comparable.
Non-realty components Are furniture, fixtures, and equipment included? For example, if a
land owner agrees to a build-to-suit lease in which all the
cost of construction, as well as the cost of interior shelving
units, counters, glass enclosures, refrigerators, and security
systems are converted to a rental payment, the lease rate will
reflect more than the income to the real property. The lease
rate could also include the value of a business franchise or a
business operation or the cost of other business licenses or
property. Leases can include real property, personal property,
or intangible property.
The amount of data needed to support a market rent estimate for a subject property
depends on the complexity of the appraisal problem and the availability of directly
comparable rentals. When sufficient, closely comparable rental data is not available, an
appraiser should include other data, preferably data that can be adjusted. When ana-
lyzed properly, a reasonably clear pattern of market rents should emerge.
Income and Expense Data

To derive pertinent income and expense data, an appraiser investigates comparable
sales and rentals of competitive income-producing properties in the same market

Interests
To a certain extent, the interest being appraised determines how rents are analyzed and estimated. The valuation
of fee simple interests in income-producing real estate begins with an estimate of the market rent the property
is capable of generating. Therefore, to value proposed projects without actual leases, properties with unleased
space, and owner-occupied properties, market rent estimates are used in the income capitalization approach.
To value the leased fee, appraisers consider contract rent for leased space, which may or may not be at
market levels, and market rent for vacant and owner-occupied space. When discounted cash flow analysis is
used, future market rent forecasts are required to estimate income after existing leases expire. It should be
emphasized that the discounting of contract rents does not result in an opinion of the market value of the fee
simple. It results in an opinion of the market value of the leased fee.
To value a leased fee in a recently completed, income-producing property that has not achieved stabilized
occupancy, an appropriate vacancy and collection loss must be forecast over an appropriate absorption or
lease-up period. Appraisals of proposed properties for lending purposes often require value estimates at dif-
ferent stages in the property’s development:
• As is
• When completed
• At stabilization
The value as is of a proposed development is typically the current value of the vacant land. The other two
values are prospective values as of the completion of construction (value considering lease-up of space at
that time) and when the property actually achieves stabilized occupancy.
or competing markets. For investment properties, current and recent incomes are
reviewed, and vacancy and collection losses and typical operating expenses are stud-
ied. Interviews with owners, tenants, and brokers in the area can provide lease and
expense data.
Appraisers try to obtain all income and expense data from the income-producing
properties used as comparables. This data is tabulated in a reconstructed operating
statement and filed by property type. (A suggested format for reconstructed operat-
ing statements is illustrated later in this chapter.)
Like expense data, rental information is difficult to obtain. Therefore, appraisers
should take every opportunity to add rents to their rental databases. Appraisers should
keep their own records because leases are rarely in public records. A separate county
index may cite the parties to recorded leases and the volume and page where leases
are recorded. Sometimes this information is listed with deeds and mortgages, but it is
not usually coded for easy identification. In certain cities, abstracts of recorded leases
are printed by private publishing services. In the majority of cases, however, leases are
not publicly recorded. Classified ads may also provide rental information and can be
found using various online sources. Many appraisers periodically check advertised
rentals and recorded rental information by property type or area. It is convenient to file
rental data under the same property use classifications used for sales data.
Income and expense figures should be converted to appropriate units of compari-
son for analysis. For example, income may be reported in terms of rent per apartment
unit, per room, per hospital bed, or per square foot. Expenses for insurance, taxes,
painting, decorating, and other required maintenance can be expressed in the same
units of comparison used for income, or they can be expressed as a percentage of the
effective gross income. The unit of comparison selected must be used consistently
throughout the analysis of the subject property and in the rental database information.

Rental property data may show vacancy rates as a percentage of potential gross
income and operating expenses as a percentage of effective gross income. This data is
essential in valuing income-producing property.
Lease Data
If written executed leases exist and the income estimate is based on the continuation
of lease income, an appraiser examines leases for provisions that could affect the
quantity, quality, and durability of property income. The appraiser may either read
the leases or rely on the client or another authorized party to disclose all pertinent
lease provisions through lease summaries or briefs. In any case, the source of infor-
mation and level of verification should be described in the scope of work section of
the appraisal report. The appraiser also analyzes the leases of competitive proper-
ties to estimate market rent and other forms of income applicable to the market for
competitive space.
Typical lease data includes
• Date of the lease
• Reference information, if the lease is recorded
• Legal description or other identification of the leased premises
• Name of lessor—i.e., owner or landlord
• Name of lessee—i.e., tenant
• Lease term
• Occupancy date
• Commencement date for rent payment
• Rent amount, including any percentage clause, graduation, and payment terms
• Rent concessions, including any discounts or benefits
• Landlord’s covenants—i.e., items such as taxes, insurance, and maintenance for
which the owner or landlord is responsible
• Tenant’s covenants—i.e., items such as taxes, insurance, maintenance, utilities,
and cleaning expenses for which the tenant is responsible
• Right of assignment or right to sublet—i.e., whether the leasehold, or tenant’s
interest, may be assigned or sublet, under what conditions, and whether assign-
ment relieves the initial tenant of future liability
• Option (or options) to renew or extend the lease, including the date of required
notice, term of renewal, rent, and other renewal provisions
• Option to purchase
• Expense caps and expense stops, escalation rent, and expense recoveries
• Options to purchase and any accompanying conditions
• Escape clauses, termination clauses, cancellation clauses, kick-out clauses, and
most-favored-tenant clauses
• Continued occupancy contingency
• Security deposits, including advance rent, bond, or expenditures by the tenant
for items such as leasehold improvements
• Casualty loss—i.e., whether the lease continues after a fire or other disaster and
on what basis

• Lessee’s improvements, including whether they can be removed when the lease
expires and to whom they belong
• Use clause
• Noncompete and exclusive use clauses
• Condemnation, including the respective rights of the lessor and the lessee if all or
any part of the property is appropriated by a public agency
• Revaluation clauses
• Dispute resolution clauses
• Special provisions (e.g., the landlord’s right to relocate a tenant at the landlord’s
expense)
Special attention should be paid to lease data on rent, rent concessions, the division
of expenses, renewal options, escalation clauses, purchase options, escape clauses,
and tenant improvements.
A sample form for analyzing a typical office lease is shown in Figure 24.1.
Rent
The amount of rent to be paid by the tenant is basic lease data. An appraiser consid-
ers rent from all sources, which may include base or minimum rent, percentage rent,
and escalation rent. The sources of rental income should be clearly identified.
Rent Concessions
In some real estate markets, landlords may give tenants concessions such as free
rent for a specified period of time or extra tenant improvements. In shopping center
leases, retail store tenants are sometimes given rent credit for interior store improve-
ments. Rent concessions often result from imbalanced market conditions and the
relative negotiating strengths of the landlord and the tenant. For example, anchor
tenants in retail complexes are generally able to negotiate leases on favorable terms
and conditions. Concessions are also used as a marketing tool in lease negotiations,
such as when the owner specifies an above-market rent with a rent concession bring-
ing it down to the market rate. Landlords offer concessions when demand is weak
and there is increased competition among landlords to attract new tenants. It is not
unusual for free rent concessions to be given outside of the lease term so that the
concessions do not appear on the written lease contract. In these situations, apprais-
ers must still consider the lease concessions when calculating the effective rent being
paid. Concessions together with tenant improvement allowances influence market
rent estimates.
Division of Expenses between the Lessor and Lessee

Most leases outline the obligations of the lessor and the lessee, specifying who must
pay for taxes, insurance, utilities, heat, janitorial service (if any), repairs, unit owner’s
or common area maintenance (CAM) expenses, and other expenses required to
maintain and operate the leased property. Appraisers should identify the division of
expenses in each lease analyzed and compare the rents and estimated rental value of
the subject space to those of the comparables. Any required adjustments for the divi-
sion of expenses in comparable properties should reflect the same lease terms and
division of expenses as the subject property.

Figure 24.1 Office Space Rental Worksheet
Building
Suite No./Identifier Floor
Lessor
Lessee Guarantor
Rentable area Usable area Rentable/usable area ratio
Lease date Commencement Expiration
Base rent CPI escalation o Yes o No o Floor or cap
Graduations

Tenant improvements (by owner)
Tenant improvements (by tenant)
Special provisions

Stop Amount Cap Amount

Who pays Lessor Lessee Stop per Sq. Ft. Cap per Sq. Ft.
Fixed expenses
Real estate taxes o o o o
Property insurance (fire, storm,
vandalism) o o o o
Variable expenses
Tenant space utilities o o o o
Common area utilities o o o o
Tenant space HVAC o o o o
Common area HVAC o o o o
Tenant space cleaning
(janitorial service) o o o o
Common area cleaning o o o o
Repairs and maintenance
Exterior o o o o
Interior o o o o
Management o o o o
Other expenses (if any) o o o o
o o o o
Renewal options
How many Years each
New rent
New escalation (and base year)
New tenant improvements
Concessions
Comments


Renewal Options
Renewal options that allow a tenant to extend the lease term for one or more pre-
scribed periods of time are frequently included in leases. A typical renewal option re-
quires that the tenant provide advance notice of the intention to renew. The lease also
must identify the length of the renewal period or periods and the rent or method of
determining the rent to be paid. The extension period rent may be set at the original
rent or at a level determined when the lease was negotiated, or it may be calculated
with a procedure or formula specified in the lease. Renewal options are binding on
the landlord but allow the tenant to make a decision based on the circumstances at
the time of renewal. Thus, renewal options tend to favor the tenant.
If the terms of the renewal option are favorable to a tenant, this fact should be not-
ed in the appraisal report, and in this case an appraiser may be justified in concluding
that the tenant would exercise the option to renew. If the terms of the renewal option
are not favorable to the tenant, this fact should still be pointed out, and the appraiser
may conclude that the tenant would not exercise the option to renew. This is particu-
larly important in discounted cash flow analysis, where it might have a significant ef-
fect on an appraiser’s selection of a projection period as well as projections of outlays
for downtime between leases, tenant improvements, and leasing commissions.
Expense Stop and Expense Cap Clauses

Leases often include clauses that limit the expenses that either the landlord or the
tenant will pay. With an expense stop, the landlord meets defined operating expenses
to a specified level, with expenses above this amount being the responsibility of the
tenant. This allows the landlord to pass through any increases above the specified
level over time and protects the landlord against unforeseen increases in expenses.
Often the level of expenses incurred during the first year of the lease is specified as
the level of the stop, although a stated amount per square foot is sometimes used.
With an expense cap, operating expenses are borne by the tenant to a specified level
above which the landlord picks up the expenses. The cap defines the tenant’s maxi-
mum obligations and limits the tenant’s exposure to the risk of increasing expenses.
Expense stop clauses are often added to traditional gross or flat rental leases. In
multitenant office buildings, increased expenses are sometimes prorated among the
tenants in proportion to the area they occupy or on some other equitable basis. The
prorated shares are then added to the tenants’ rents. The expenses allocated to vacant
space are normally paid by the owner.
Sometimes a single stop provision is used to cover all the expenses to be passed
through to the tenants. Alternatively, an expense stop might be specified for individ-
ual expense items. For example, tax stop clauses provide that any increases in taxes
over a specified level be passed on to the tenant.
Escalation Clauses and Expense Recovery Clauses

An escalation clause helps a landlord offset increases in operating expenses in non-
net lease situations, with expense increases passed on to tenants on a pro rata basis
through an adjustment to rent.
An expense recovery clause stipulates that some or all operating expenses paid
by the landlord are recoverable from the tenant. In different parts of the country, ex-
pense recoveries are known as reimbursables, billables, or pass-throughs. Some of these
items (e.g., common area maintenance charges) may be considered under operating

expenses, while others may be considered under replacement allowances. Expense
recoveries are usually treated as separate revenue items, and recoverable expenses
are usually deducted as expenses in income and expense statements. This meth-
odology allows for the consideration of landlord exposure to tenant-paid expenses
on vacant space. The analysis should consider whether the recoverable items have
historically been recovered and the probability of recovery in the future.
Purchase Options
Certain leases include a clause granting the lessee (tenant) an option to purchase the
leased property or to match any offer to purchase. The relationship of contract to
market rent and other factors will influence the likelihood of a tenant exercising such
an option. In some cases, this option must be exercised on the lease termination date
or at some point or points during the lease term. In other cases, this option may be
available at any time. The option price may be fixed or it may change periodically
based on an empirical formula, depreciated book value, or revaluation of the prop-
erty. A purchase option may only give the lessee the right to purchase the property
or make an offer if an offer to purchase is made by a third party. This provision is re-
ferred to as a right of first refusal. A purchase option can restrict marketability and the
price a third-party buyer will pay for the property. The option price, if stated, may
represent a limit on the market value of the leased fee estate.
Escape, Kick-Out, Cotenancy, and Buyout Clauses

Landlords and tenants may have reasons for terminating a lease prior to the end of a
lease term, and a lease agreement often includes language that protects both parties
in case of a default or other form of termination. For example, an escape clause may
permit a tenant to cancel a lease under circumstances that would not ordinarily be
considered justification for lease cancellation. A condemnation or casualty clause
might allow the tenant to cancel the lease if a condemnation or casualty loss hinders
operations. A casualty clause may stipulate that the landlord be allowed a reasonable
amount of time to make necessary repairs and provide for appropriate abatement of
rent in the interim. A landlord might include a demolition clause in a lease to pre-
serve the prospects for sale or redevelopment of the site. This type of escape clause
can affect rent levels and market value.
A kick-out clause written into a lease allows a landlord to cancel a lease upon the
occurrence of a specific event, e.g., if sales have not achieved a predetermined level
after a certain period of time. Kick-out clauses may create risk and warrant adjust-
ments to discount rates or capitalization rates used in direct capitalization.
Co-tenancy clauses in retail leases permit tenants to reduce the rent or terminate
a lease if the landlord has not replaced an anchor tenant or other specified tenant or
tenant types within a predetermined period. For a tenant, the purpose of a cotenancy
clause is typically to ensure a certain level of traffic within a shopping center through
the continuous operation of other tenants. Cotenancy clauses may have a significant
effect on property performance if they are exercised.
In the event of bankruptcy of either the landlord or tenant, the US Bankruptcy
Code (last revised in 2019) is generally agreed to supersede any lease provisions relat-
ing to the bankruptcy of one of the parties. The bankruptcy of a tenant can have a sig-
nificant effect on the value of commercial properties because of the length of typical
leases. However, section 365 of the Bankruptcy Code caps the damages a landlord can

claim from the rejection of a long-term lease contract by a party in Chapter 11 bank-
ruptcy proceedings, although the courts have interpreted the language differently.
Buyout clauses provide for a payment by either a landlord or a tenant to the
other to induce the cancellation of a lease. The amount of the payment may be set by
the lease or be negotiated at the time of the cancellation.
Termination clauses in leases permit the tenant to terminate the lease within a
specified period after giving notice.
Most-favored-tenant clauses are sometimes found in leases to major tenants. The
terms of these leases require the landlord to reduce the lease rate per square foot for
this tenant to equal a lower lease rate subsequently executed with another tenant.
Continued Occupancy Clauses

Multitenant properties may be subject to leases that condition the continued occu-
pancy of one tenant on the occupancy of another tenant. An anchor tenant’s decision
to vacate during the lease term can precipitate the departure of other tenants as well.
In appraising shopping centers, the probability of an anchor tenant leaving at or
before expiration of the current lease must be carefully analyzed. This is true whether
or not the satellite (i.e., non-anchor) stores have leases conditioning their occupancy
on the continued occupancy of the anchor tenant. Small stores are often unable to
continue operation if the anchor leaves the center.
When capital expenditures that are not accounted for in the asking rent are made
by the lessor, reimbursement may be accomplished through marginally higher rent
that amortizes the lessor’s expenditures over all or part of the lease period. If capital
expenditures are made by the tenant, the lessor may reduce the tenant’s rent for all or
part of the lease term as compensation for such tenant expenditures. In many retail
environments, the rents vary directly with the level of build-out provided to the ten-
ant. When using these leases as comparable data, the level of build-out supplied with
the rent is an important element of comparison.
Tenant improvements are driven by the market—i.e., they are only done if the
market dictates it. Also, tenant improvements are dictated by the particular lease agree-
ment and do not apply to all property types. The standard maintenance and upkeep
of an apartment unit before renting the unit to a new tenant is not usually considered
a tenant improvement, unless the cleaning and refurbishment exceed the typical levels
needed to maintain the property’s competitiveness in the market. If the tenant improve-
ments directly affect net operating income and are recorded above the NOI line in a
reconstructed operating statement, they are considered above-the-line expenses. More
often, they are treated as below-the-line expenses.
A developer or owner may be responsible for a certain level of build-out or
tenant improvements, and that will be reflected in the rent as defined in a tenant
workletter. Improvements in excess of that level are the responsibility of tenants and
are not reflected in the rent, or they may be provided by the landlord and amortized
over time. The level of build-out may be different for new space versus retrofitting
existing space, and the level of tenant improvements may be different for a new ten-
ant and a renewal tenant.
Noncompete, Dark Store, and Exclusive Use Clauses

Leases may contain a provision that prohibits tenants from operating a business in a
nearby, competing shopping center. For example, a tenant who sells sporting goods

may agree not to open another, competing sporting goods facility near the shopping
center. This type of non-compete clause is known as a radius restriction.
In some jurisdictions, a lease may include a clause stating that the tenant must
continue to occupy the property throughout the term of the lease and is barred from
opening a competitive store within a certain period after the expiration date of the
lease. A dark store clause protects a landlord, whose property could be put in a poor
releasing position if a tenant moves out and opens another store within the same
trade area. A dark store clause may be especially important in a percentage lease
involving an anchor or other major tenant. A dark store clause may sometimes be
referred to as a go dark clause, which is also sometimes used to describe the kick-out
clause discussed previously. Alternatively, what is described as a go dark clause may
allow a tenant to take a leased space out of service while continuing to pay rent.
An exclusive use clause may be written into a lease to control the retail mix of the
shopping center. Such a clause may also be sought by a tenant who wants to achieve
some degree of monopoly status (e.g., a fast food chain that wants to have the only
restaurant of its type in the shopping center).
Developing Reconstructed Operating Statements

Assessing the earning power of a property means reaching a conclusion regarding
its net operating income expectancy. Appraisers estimate income and expenses after
researching and analyzing the following:
• The income and expense history of the subject property
• Income and expense histories of competitive properties
• Recently signed leases, proposed leases, rejected lease proposals, and asking
rents for the subject and competitive properties
• Actual vacancy levels for the subject and competitive properties
• Management expenses for the subject and competitive properties
• Operating expense data and operating expenses at the subject and competitive
properties
• Forecast changes in taxes, energy costs, and other operating expenses
Appraisers often present this information in tabular form to assist the reader of
the report. Income and expenses are generally reported in annual or monthly dollar
amounts and analyzed in terms of nominal dollar amounts per unit of rentable area
or another unit of comparison. To show how historical and forecast data on operating
expenses is commonly arrayed, Table 24.2 summarizes the operating expense history
of a downtown office building with 60,000 square feet of rentable space. Table 24.3
summarizes the operating expenses of five comparable properties in the same market
area and allows for easy comparison of the subject property and the comparables. It
is obvious that the total operating expenses of the subject, at $15.82 per square foot
for the year being studied, are significantly higher than those of the comparables,
which range from $13.73 to $15.07 per square foot. For most of the operating ex-
penses listed, the per-unit expenses for the subject fall within the ranges set by the
comparable properties; but the expenses for electricity, at $4.14 per square foot, and
cleaning, at $2.28 per square foot, are higher than for any of the comparables. In this

Table 24.2 Subject Property Operating Expense History
Three Years Ago Two Years Ago One Year Ago Current Year Budget
Per Square Per Square Per Square Per Square
Dollars Foot Dollars Foot Dollars Foot Dollars Foot
Fixed expenses
Real estate taxes $232,812 $3.88 $272,378 $4.54 $314,433 $5.24 $323,400 $5.39
Insurance 7,134 0.12 7,050 0.12 19,875 0.33 20,100 0.34
Variable expenses
Electricity $200,390 $3.34 $216,632 $3.61 $211,789 $3.53 $248,350 $4.14
Steam heat 79,211 1.32 71,390 1.19 72,675 1.21 85,250 1.42
Cleaning 117,102 1.95 109,775 1.83 128,987 2.15 136,750 2.28
Payroll 8,432 0.14 10,208 0.17 11,386 0.19 12,600 0.21
Repairs and
maintenance 17,388 0.29 30,688 0.51 38,875 0.65 52,825 0.88
Water and sewer 3,010 0.05 3,030 0.05 2,412 0.04 4,800 0.08
Administrative, legal,
and accounting 1,180 0.02 1,778 0.03 10,856 0.18 10,850 0.18
Management fees 47,570 0.79 49,300 0.82 50,100 0.84 53,500 0.89
Miscellaneous 3,031 0.05 88 0.001 610 0.01 600 0.01
Total operating expenses $717,260 $11.95 $772,317 $12.87 $861,998 $14.37 $949,025 $15.82
Note: Figures have been rounded.
Table 24.3 Analysis of Operating Expenses of Comparable Properties

Comparable Properties
A B C D E
Subject Property 130 Main 110 Second 717 Fourth 133 Third One Commerce
Pro Forma Street Avenue Avenue Avenue Plaza
Operating year Current 1 year ago 1 year ago 1 year ago 1 year ago 1 year ago
Year built 7 years ago 7 years ago 18 years ago 25 years ago 22 years ago 8 years ago
Rentable area
in square feet 60,000 75,000 49,411 56,411 52,000 66,000
Operating Expenses*
Fixed expenses
Real estate taxes $5.39 $5.51 $5.48 $5.01 $5.47 $5.35
Insurance 0.34 0.18 0.27 0.30 0.51 0.27
Variable expenses
Electricity $4.14 $4.03 $3.47 $3.31 $3.25 $3.45
Steam heat 1.42 1.25 1.60 1.35 1.75 1.55
Cleaning 2.28 1.61 1.38 1.27 1.28 1.30
Payroll 0.21 0.25 0.32 0.78 0.73 0.21
Repairs and
maintenance 0.88 0.45 0.63 0.98 0.99 0.38
Water and sewer 0.08 0.08 0.08 0.08 0.09 0.10
Administrative, legal,
and accounting 0.18 0.19 0.19 0.26 0.08 0.11
Management fees 0.89 0.80 0.80 0.80 0.90 1.00
Miscellaneous 0.01 0.02 0.01 0.02 0.02 0.01
Total operating expenses $15.82 $14.37 $14.23 $14.16 $15.07 $13.73
* Per square foot

case, the appraiser will have to investigate the reasons for the higher costs of electric-
ity and cleaning for the subject property.
After thoroughly analyzing property and lease data for the subject and compara-
ble properties, an appraiser develops a net operating income estimate for the subject
property. If the appraiser is focusing on the benefits accruing to the equity invest-
ment, the equity income is also estimated.
Potential Gross Income

Appraisers usually analyze potential gross income on an annual basis. Potential gross
income comprises
• Rent for all space in the property—e.g., contract rent for current leases (when ap-
praising the lease fee interest), market rent for vacant or owner-occupied space,
percentage and overage rent for retail properties
• Rent from escalation clauses
• Reimbursement income
• All other forms of income to the real property—e.g., income from services sup-
plied to the tenants, such as secretarial service, switchboard service, antenna con-
nections, storage and garage space, and income from coin-operated equipment
and parking fees
Because service-derived income may or may not be attributable to the real property,
an appraiser might find it inappropriate to include this income in the property’s
potential gross income. An appraiser may treat such income as business income or
as personal property income, depending on its source. If a form of income is subject
to vacancy and collection loss, it should be incorporated into potential gross income,
and the appropriate vacancy and collection charge should be made to reflect effective
gross income.
Vacancy and Collection Loss

Vacancy and collection loss is an allowance for reductions in potential gross income
attributable to vacancies, tenant turnover, and nonpayment of rent or other income
over the projection period. This line item considers two components:
• Physical vacancy as a loss in income
• Collection loss due to default by tenants
The rents collected each year are typically less than annual potential gross income,
so an allowance for vacancy and collection loss is usually included in the appraisal
of income-producing property. The allowance is usually estimated as a percentage of
potential gross income, which varies depending on the type and characteristics of the
property, the quality of its tenants, the type and level of income streams, current and
projected market supply and demand conditions, and national, regional, and local
economic conditions.
An appraiser should survey the local market to support the vacancy estimate.
Published surveys of similar properties under similar conditions may be helpful but
should be used with caution as they are not necessarily indicative of current, local
market conditions. The conclusion in the income capitalization approach may differ
from the current vacancy level indicated by primary or secondary data because the

estimate reflects typical investor expectations for the subject property only over the
projection period.
Effective Gross Income

Effective gross income is calculated as the potential gross income minus the vacancy
and collection loss allowance.
Operating Expenses
Operating expenses may be recorded in categories selected by the property owner.
The records also may follow a standard system of accounting established by an as-
sociation of owners or by accounting firms that serve a particular segment of the real
estate market. Generally, operating expenses are divided into three categories:
• Fixed expenses
• Variable expenses
• Replacement allowance
However operating expenses are organized, an appraiser analyzes and reconstructs
expense statements to develop an estimate of the typical operating expense forecast
for the property on an annual cash basis.
Fixed Expenses
Most reconstructed operating statements contain line items for real estate taxes and
insurance costs. Because the concept of market value presumes a sale, the real estate
tax projection should consider the impact of the presumed sale on the anticipated
assessed value and taxes. Tax data can be found in public records, and the assessor’s
office may provide information about projected changes in assessments or rates and
their probable effect on future taxes. In some jurisdictions, a property is reassessed
to reflect its market value upon sale. When this is the case, the real estate taxes will
need to reflect the reassessment. If a property is assessed unfairly, the real estate tax
expense may need to be adjusted in the reconstructed operating statement. If the
subject property has an unusually low assessment compared to similar properties or
appears to deviate from the general pattern of taxation in the jurisdiction, the most
probable amount and trend of future taxes must be considered. Any past changes in
the assessment of the subject property should be studied. If the assessment is low, the
assessor may be required by law to raise it. If the figure is high, however, a reduction
may not be easy to get. In projecting real estate taxes, an appraiser tries to anticipate
tax assessments based on jurisdictional laws and regulations, past tax trends, present
taxes, the municipality’s future expenditures, the perceptions of market, and local
assessment practices.
For proposed properties, properties that are not currently assessed, or proper-
ties that will be reassessed to reflect market value upon sale, appraisers can develop
operating statement projections without including real estate taxes. The resulting
estimate is net operating income before real estate taxes, and a provision for real
estate taxes is included in the capitalization rate used to convert this net income into
property value. For example, suppose that real estate taxes are typically 2% of market
value and net operating income after real estate taxes would normally be capitalized
at 8% to derive an opinion of market value for the subject property. In this case, the
estimated net operating income before real estate taxes could be capitalized at 10%

(8% + 2%) to derive a property value indication. (This is known as a loaded capitaliza-
tion rate. Note that the tax load should represent the landlord’s portion and may need
to be adjusted for vacancy.)
Alternatively, real estate taxes for a proposed project might be based on building
costs or the taxes paid by recently constructed, competitive properties. Appraisers
should exercise care to determine applicable procedures in the jurisdiction in which
the property is located. Any unusual, unpaid special assessments or other mandatory,
one-time expenses should be addressed as a lump-sum adjustment at the end of the
analysis, if that is what market participants would do.
An owner’s operating expense statement may show the insurance premiums
paid on a cash basis. If the premiums are not paid annually, they must be adjusted to
an annual expense before they are included in the reconstructed operating statement.
Fire, extended coverage, and owner’s liability insurance are typical insurance items.
Elevators, boilers, plate glass, or other items may also be insured, depending on the
property type. An appraiser must determine the amount of insurance and, if it is
inadequate or superadequate, adjust the annual cost to indicate appropriate coverage
for the property. As with all projected expenses, the insurance expense estimate must
reflect dynamic changes in the market such as the increase in insurance costs follow-
ing an event like a catastrophic hurricane.
Insurance on business inventory, business liability, and other business property
is the occupant’s responsibility and therefore should not be charged to the operation
of the real estate. When questions concerning coinsurance or terms of coverage arise,
an appraiser might need to obtain professional insurance counsel. It is common for
large real estate investors to obtain insurance premium discounts through blanket
insurance policies on groups of properties. As these discounts apply to the particular
business interest of that particular owner, these discounts should be analyzed by the
appraiser to apply the most appropriate insurance premium for the subject property
without consideration of any blanket policy discounts.
Variable Expenses
Operating statements for large properties frequently list many types of variable ex-
penses such as the following:
• Management
• Utilities—e.g., electricity, gas, water, and sewer
• Heat
• General payroll
• Cleaning
• Maintenance and repair of structure
• Decorating
• Grounds and parking area maintenance
• Miscellaneous—e.g., administrative, security, supplies, rubbish removal, and
exterminating
• Leasing commissions
Management services may be contracted or provided by the property owner. The
management expense may have two components: a professional property manage-

ment fee and other expenses related to the operations of the asset. The property
management fee is usually expressed as a percentage of effective gross income,
which conforms to the local pattern of such charges for typical management.1 For
some property types there may be additional management expenses such as on-site
supervision and the cost of maintaining and operating on-site facilities such as offices
or managers’ apartments. These additional management expenses, in conjunction
with other management expenses such as the cost of telephone service, clerical help,
legal or accounting services, printing and postage, and advertising and promotion,
may be accounted for elsewhere in the expense statement. Management expenses
may be included among recoverable operating expenses in certain markets for some
property types. For some property types (such as multi-family properties), the use of
a unit may be a part of the local manager’s compensation. The appraiser may need to
analyze the total in-kind payment to make sure it is consistent with market trends.
In some markets, standard retail leases contain a provision for levying adminis-
trative charges as a percentage of common area maintenance charges. These charges
are typically treated as a mark-up to tenant reimbursements and may replace or be
added to the management fee.
Utility expenses for an existing property are usually projected based on an analy-
sis of past charges and current trends. The subject property’s utility requirements
can be compared with known utility expenses per unit of measure—e.g., per square
foot, per room, per apartment unit—for similar properties to estimate probable future
utility expenses. Hours of tenant operation may prove to be significant in the analy-
sis. For example, the number of nights per week that a shopping center is open and
the hours of after-dark operation will directly affect electricity consumption and may
also affect expenses for maintenance and garbage removal. In analyzing utility ex-
penses, appraisers recognize local circumstances and the current and expected future
cost of all applicable utilities. The presence of “green,” or energy-efficient building
features such as solar panels can have a significant effect in reducing utility costs.
Utilities may be paid entirely by the property owner or entirely by the tenant, or they
may be shared. These expenses may be recouped as part of common area reimburse-
ments or through a different utility reimbursement plan, e.g., a ratio utility billing
system (RUBS) in a multifamily property.
Although the cost of electricity for leased space is frequently a tenant expense,
and therefore not included in the operating expense statement, the owner may be
responsible for lighting public areas, for the power needed to run elevators and other
common building equipment, and for the cost of vacant space during the tenant
turnover periods. Some regional shopping centers purchase electricity on a wholesale
basis and resell it to the tenants on a retail basis, keeping the difference as profit. If
this is the case, an appraiser should consider whether the profit component repre-
sents income to the business or income to the real property and whether this activity
is legal in that particular jurisdiction.
When used for heating and air-conditioning, gas can be a major expense item that
is either paid by the tenant or paid by the property owner and reflected in the rent.
1. Actual property management should be distinguished from asset management. Large, investment-grade properties are often held as part of a
portfolio that includes both securities and real estate. The managers of these portfolios make critical decisions concerning when to acquire and
sell a real estate asset, how to finance or when to refinance, and when to reposition a property in the market. Though their roles are distinct, the
functions of a property manager and an asset manager may sometimes be intertwined. Asset management fees should not be included among
the items enumerated as operating expenses for real property.

The cost of water is a major consideration for industrial plants that use processes
that depend on water and for multifamily projects in which the cost of sewer service
is usually tied to the amount of water used. It is also an important consideration for
laundries, restaurants, taverns, hotels, and similar operations. The leases for these
properties may stipulate that the tenant pay this expense. If the owner typically pays
for water, this charge should be included in the expense statement.
In municipalities with sewerage systems, a separate charge for use of the system
may be paid by the tenant or the owner of the real estate. This total expense may be
substantial, particularly for properties with high personal use, such as hotels, motels,
recreational facilities, apartments, and office buildings.
The cost of heat is generally a tenant expense in single-tenant properties, indus-
trial and retail properties, and apartment and office projects with individual heating
units. It is a major expense item shown in operating statements for centrally heated
apartment and office properties. The fuel consumed may be oil, gas, electricity, or
public steam. Heating supplies, maintenance, and workers’ wages are included in
this expense category under certain accounting methods.
Public steam suppliers and gas companies maintain records of fuel consumption
and corresponding degree days from year to year. (One degree day is equal to the
number of degrees, during a 24-hour day, that the mean temperature falls below 65°
Fahrenheit, which is the base temperature in the United States.) An appraiser can use
these records and fuel cost data to compare the property’s heating expense for the
most recent years with a typical year. Probable changes in the cost of the fuel used
should be reflected in the projection.
Air-conditioning expenses may be charged under the individual categories of
electricity, gas, water, payroll, and repairs, or heating and air-conditioning may be
combined under the category of heating, ventilation, and air-conditioning (HVAC).
The cost of air-conditioning varies with local climatic conditions and the type of sys-
tem installed. A projection of this expense may be based on typical unit charges for
the community or the property type. Many office and apartment have central HVAC
systems, and operating expenses are included in their annual statements. Most retail
properties and some apartment buildings have individual heating and air-condition-
ing units that are operated by the tenants. The maintenance and repair of these units,
particularly in apartments, may continue to be the property owner’s obligation.
General payroll expenses include payments to all employees whose services are
essential to property operation and management but whose salaries are not included
in other specific expense categories. In some areas the cost of custodial or janitorial
service is based on union wage schedules. In others the charge is negotiated based
on local custom and practice. If a custodian or manager occupies an apartment as
partial payment for his or her services, the apartment’s rental value may be included
as income and an identical amount deducted as an expense. In certain properties ad-
ditional expenses are incurred to pay the salaries of security personnel, porters, and
elevator operators. Unemployment and social security taxes for employees may be
included under general payroll expenses or listed in a separate expense category.
In office buildings the cost of cleaning or janitorial services is a major expense
and usually includes two elements: cleaning costs and cleaning supplies. It is usually
estimated in terms of cost per square foot of rentable area, whether the work is done
by payroll personnel or by an outside cleaning firm. This expense is equivalent to

maid service or housekeeping in hotels and furnished apartments. In hotels and mo-
tels, cleaning expenses are attributed to the rooms department and may be estimated
as a percentage of the department’s gross income. The percentage established reflects
the property’s previous experience and industry standards. Cleaning may be an
owner or tenant expense, depending on the property type and lease provisions.
Maintenance and repair expenses are incurred during the year to maintain the
structure and its major components, keep them in good working order, and maintain
rent levels. These expenses may cover roof repair, window caulking, tuckpointing,
exterior painting, and the repair of heating, lighting, and plumbing equipment. Main-
tenance costs may be paid by the tenants and repair costs by the owners. There may
be a contract for elevator maintenance and repair, and often owners are still respon-
sible for maintenance of the roof, HVAC system, and general structure. However,
the coverage of these contracts varies, and appraisers must determine any additional
operating expenses not covered by the maintenance contract. A contract covering
air-conditioning equipment, for example, would probably be included in the air-
conditioning expense category.
Alterations, including major replacements, modernization, and renovation,
may be considered capital expenditures and therefore are not included as a periodic
expense under repair and maintenance. If the lessor makes alterations in the rented
space, the expense may or may not be amortized by additional rent. In some cases,
the tenant may pay for alterations.
The total expense for property maintenance and repair is affected by the extent to
which building components and equipment replacements are covered in the replacement
allowance as well as the age, condition, and functional utility of the property. If an exten-
sive replacement allowance is included in the reconstructed operating statement, annual
maintenance and repair expenses may be reduced. Similarly, if an owner cures items of
deferred maintenance, the annual maintenance and repair expenses may be reduced.
For some properties, historical expense records may include typical repairs and
even capital expenses in an overall category called “repairs and maintenance.” If this
is the case, the reconstructed operating statement will need to show an adjustment to
the historical data, especially where separate replacement allowances are included.
The goal of the analysis is to consider all appropriate expenses over time as well as a
replacement allowance to ensure the ongoing repair of major building components.
(If revenue is based on total assets of the business, replacements for tangible personal
property may be involved.) Also, there may be some crossover in the tenant improve-
ment category and the replacement allowance or repair category. The same method
should be applied to any comparable sales information to ensure consistency when
the various rates and ratios are extracted and then applied to the subject property.
Decorating expenses may include the cost of interior painting, wallpapering, or
wall cleaning in tenant or public areas. Decorating expenditures may vary with local
practice and the supply and demand for space.
The cost of maintaining grounds and parking areas can vary widely depend-
ing on the type of property and its total site area. The cost of snow removal may be
substantial in northern states, particularly for properties with outdoor parking in ad-
dition to sidewalks and driveways. Hard-surfaced public parking areas with drains,
lights, and marked car spaces are subject to intensive wear and can be expensive to
maintain. These expenses may be entirely or partly reimbursed through an increment

added to the rents of tenants served by the facility. In this case both the added income
and the added expenses are included in the reconstructed operating statement. Land-
scaping and lawn maintenance are also covered by this expense category.
Certain types of buildings in some areas may require security provisions, the cost
of which will vary according to the number of employees needed to control entry and
exit and to circulate through the property. Maintenance and energy expenses may
also be incurred if security provisions include electric alarm systems, closed circuit
television, or flood lighting.
The cost of cleaning materials, office supplies, and miscellaneous items not cov-
ered elsewhere may be included under supplies. Garbage and pest control services
are usually contracted and their cost is included in the expense statement.
Expenses for miscellaneous items vary with property type. If this expense cat-
egory represents a significant percentage of effective gross income, however, it may
be wise to explain individual expense items or reallocate them to specific categories.
Replacement Allowance
A replacement allowance provides for the periodic replacement of building com-
ponents that wear out more rapidly than the building itself and must be replaced
during the building’s economic life. Depending on local practice, the replacement
allowance may be reflected explicitly as an expense or implicitly in the capitalization
or discount rate.
If shown specifically, the annual replacement allowance for each component of
a property is usually estimated as the anticipated cost of its replacement prorated
over its total economic life, provided this does not exceed the total economic life of
the structure. Some appraisers use simple averaging (with or without calculating
a sinking fund payment), while others prefer to show the actual cost and timing of
these replacements. There are various ways to calculate a replacement allowance. The
calculation method used should be consistent with the manner in which replacement
allowances were treated for purposes of extracting capitalization rates from the com-
parable sales or discount rates from market data. New elevators or other components
that are expected to have useful lives that equal or exceed the remaining economic
life of the structure do not require an allowance for replacement, unless making re-
placements or installing new equipment increases the remaining economic life of the
structure beyond that of the long-lived items. Examples of building components that
may require a replacement allowance include
• Roof covering
• Carpeting
• Kitchen, bath, and laundry equipment
• HVAC compressors, elevators, and boilers
• Specific structural items and equipment that have limited economic life expectancies
• Sidewalks
• Driveways
• Parking areas
• Exterior painting and weatherproofing for windows
The scope of items to be covered in a replacement allowance is a matter of ap-
praisal judgment based on market evidence. However, the magnitude and coverage

Leasing Commissions
Leasing commissions are fees paid to an agent for leasing tenant space. In direct capitalization, leasing com-
missions are either treated as a normalized annual expense or included below the line in the reconstructed
operating statement, depending on local market convention. In discounted cash flow analysis, leasing com-
missions are typically included in the time period when they are expected to occur. Leasing commissions may
or may not be reflected in the operating statements provided by the owner. Initial leasing commissions, which
may be extensive in a new development, are usually treated as part of the capital expenditure for developing
the project. These initial leasing commissions are not included as ongoing periodic expenses.
A blended rate can be developed to reflect leasing commission costs for both existing leases and new
leases. For example, if the tenant renewal ratio for a property is 70%, the leasing commission for existing ten-
ants is 2.5%, and the leasing commission for new tenants is 6%, a blended rate can be developed as follows:
0.70 × 0.025 = 0.0175
0.30 × 0.060 = + 0.0180
Blended rate = 0.0355 (3.55%)
This blended rate is then applied to existing tenant leases as they expire.
of the replacement allowance is related to the annual repair and maintenance expens-
es of the property for the specific components considered in the allowance. Historical
operating statements prepared on a cash basis may include periodic replacement ex-
penses under repair and maintenance. If comprehensive provisions for replacements
are made in the reconstructed operating statement, these charges may be duplicated
unless the annual maintenance expense estimate is reduced.
In certain real estate markets, space is rented to a new tenant only after sub-
stantial interior improvements are made. If this work is performed at the landlord’s
expense and is required to achieve the estimated rent, the expense of these improve-
ments may be included in the reconstructed operating statement as part of the
replacement allowance in a separate “tenant improvements” or “capital expenditure”
category, depending on local practice.
A total expense estimate that provides for all items of repair, maintenance, and
replacement may exceed the actual expenditures shown in the owner’s operating
statements for recent years. This is particularly common when the building being
appraised is relatively new and the owner has not incurred many capital or repair
expenses. In preparing a reconstructed operating statement for a typical year, an
appraiser recognizes that replacements must be made eventually and that replace-
ment costs affect operating expenses. These costs can be reflected in increased annual
maintenance costs or, on an accrual basis, in an annual replacement allowance.
An appraiser must know whether or not a replacement allowance is included
in any operating statement used to derive a market capitalization rate for use in the
income capitalization approach. It is essential that the income statements of comparable
properties be consistent. Otherwise, adjustments will be required. A capitalization rate
derived from a comparable sale property is valid only if it is applied to the subject prop-
erty on an equivalent basis. Consequently, a rate derived from a sale with an expense
estimate that does not provide for a replacement allowance should not be applied to
an income estimate for a subject property that includes such an allowance without an
adjustment that reflects the difference. Investor survey rates may or may not include
deductions for replacement allowances, and appraisers must exercise caution in apply-

Exclusions from Reconstructed Operating Statements
The operating statements prepared for real estate owners typically list all expenditures made during a spe-
cific year. An owner’s statement may include nonrecurring items that should not be included in an expense
estimate intended to reflect typical annual expenses. Such a statement may also include items of business
expense or costs associated with the specific circumstances of ownership.
A reconstructed operating statement represents an opinion of the probable future net operating income
of an investment.* Certain items included in operating statements prepared for property owners should be
omitted in reconstructed operating statements prepared for appraisal purposes. These items include book
depreciation, depletion allowances or other special tax considerations, income tax, special corporation costs,
additions to capital, and loan payments.
Book Depreciation
The book depreciation for the improvements on a parcel of real estate is based on historical cost or another
previously established figure that may be unrelated to current market value. Moreover, book depreciation is
based on a formula designed for tax purposes. The capitalization method and procedure selected provide for
the recapture of invested capital, so including depreciation in the operating expense statement is redundant.
Depletion Allowances or Other Special Tax Considerations
A depletion allowance is an accounting process that allows for lower taxation of the revenue generated by
extracting natural resources from a property because there is less oil, coal, natural gas, or other minerals left
in the ground. The concept of depletion is similar to the depreciation of assets, and including the depletion
allowance in the operating expenses would be redundant for the same reasons given for book depreciation.
Income Tax
The amount of income tax varies with the type of property ownership—i.e., the property may be held by a
corporation, a partnership, a public utility, or an individual. The expected or average income tax of the owner
is not an operating expense of the property. It is an expense of ownership.
Special Corporation Costs
The expenses attributable to corporate operations also pertain to the type of ownership. Corporate expenses
are not part of a reconstructed operating statement developed for appraisal purposes.
Additions to Capital
Expenditures for capital improvements usually do not recur annually and therefore should not be included in
an estimate reflecting the typical annual expenses of operation. Capital improvements may enhance value
by increasing the annual net operating income or economic life of the property, but the capital expenditure is
not a periodic operating expense.
The exclusion of capital expenditures is specific to reconstructed operating statements, which are used to
calculate net operating income. An average annual expectation may be included in the replacement reserve.
When cash flows are estimated for a discounted cash flow analysis, capital expenditures may be deducted
from the net operating income in the year the expenditure is expected to occur and not averaged on an
annual basis. This is particularly important when the property’s future net operating income is based on the
assumption that the capital expenditure will be made. In this case, failure to account for the capital expen-
diture could result in an overstatement of value. Similarly, value may be understated if capital improvements
are presumed to have been “written off” without appropriately considering their contribution to value or their
additions to the total capital invested.
Loan Payments
Operating statements prepared by owners often reflect loan payments in the form of periodic debt service
and may include a loan payoff. These payments are not included in the reconstructed operating statement
because net operating income is defined to exclude mortgage debt service.
* Some practitioners use the term pro forma synonymously with reconstructed operating statement. Technically, a pro forma is a finan-
cial statement—e.g., a balance sheet or income statement used by a business developed “according to form.” In appraisal practice, a
reconstructed operating statement is developed to conform to the definition of net operating income used by appraisers, which gener-
ally differs from the definition of income used by accountants. Thus, a reconstructed operating statement drawn up by an appraiser will
usually differ from a typical pro forma income statement prepared by an accountant.

ing capitalization and discount rates from surveys. Most surveys explain the basis for
their rates. If they do not, an appraiser may contact the survey’s author for clarification.
Total Operating Expenses

Total operating expenses are the sum of fixed and variable expenses and the replace-
ment allowance in the reconstructed expense estimate.

After total operating expenses are deducted from effective gross income, the remain-
der is the net operating income.
Additional Calculations
After an appraiser calculates net operating income, further calculations may be
needed to determine
• Mortgage debt service
• Equity income
• Expense and income ratios
Mortgage Debt Service

Mortgage debt service is the annual sum of all mortgage payments. Mortgage debt
service is deducted from net operating income to derive equity income, which is used
in certain capitalization procedures. The definition of market value is based on financ-
ing terms compatible with those found in the market. Thus, in estimating market
value, the mortgage debt service to be deducted from the net operating income must
be based on market terms. In some cases, an appraiser may be asked to develop an
opinion of the value of the equity investor’s position based on existing or specified
financing. In this case the debt service would reflect the specific terms in the existing
or specified mortgage (or mortgages).
Equity Income
Equity income (IM) is the income that remains after all mortgage debt service is de-
ducted from net operating income (IO - IM) = IM.
Expense and Income Ratios

The ratio of total operating expenses to effective gross income is the operating ex-
pense ratio (OER). The complement of this ratio is the net income ratio (NIR), which
is the ratio of net operating income to effective gross income. These ratios tend to
fall within certain ranges for specific categories of property. Experienced appraisers
recognize appropriate ratios, so they can identify statements that deviate from typical
patterns and require further analysis. They understand that risk varies inversely with
the net income ratio because, for properties with low NOI ratios, small changes in ef-
fective gross income will have an inordinately large effect on net income.
Nationwide studies of apartment, office building, and shopping center properties
conducted by the Institute of Real Estate Management (IREM), the Building Own-
ers and Managers Association International (BOMA), and the Urban Land Institute
(ULI) can often be used as general guides in assessing the reasonableness of operat-
ing expense ratios. Similar studies are also available for hotels, industrial properties,
and self-storage properties. Sometimes local IREM or BOMA chapters or real estate

appraisal organizations and their chapters conduct and publish studies of operat-
ing expenses that can be used as market indicators. Published studies are useful, but
appraisers must still develop operating expense ratios from comparable properties
in the subject property’s market or verify that published ratios are applicable to this
market. Appraisers must also consider the applicability of the survey data to the
physical characteristics of the subject property. For example, an appraiser should
probably not use an IREM survey of buildings with an average building size of 400
units in the analysis of a 30-unit apartment building.

Direct Capitalization 25
Direct capitalization is a method used in the income capitalization approach to convert

a single year’s income expectancy into a value indication. This conversion is accom-
plished in one step, either by dividing the net operating income estimate by an appro-
priate income rate or by multiplying the income estimate by an appropriate factor.1
Direct capitalization is widely used when properties are already operating on a
stabilized basis, or those that are being valued under
the assumption that they are stabilized. Direct capi-
talization can also be used when there is a sufficient
The basic formulas for direct
supply of comparable sales with similar risk levels, capitalization are
incomes, expenses, physical and locational character- I I
istics, and future expectations from which to extract I = R × V R = V=
V R
capitalization rates or when there are alternate methods V V
V = I × F I= F=
for deriving capitalization rates. The direct capitaliza- F I
tion method may be less useful for properties going where I is income, R is
through an initial lease-up period and for properties capitalization rate, V is value,
with income or expenses that are expected to change and F is factor.
in an irregular pattern over time. Investors often have
minimum first-year capitalization rate requirements. In I
these cases, comparables with similar future expecta-
tions may not be available and a yield capitalization
technique may be more appropriate.
The advantages of direct capitalization are (1) it is R V
simple to use and easy to explain, (2) it often expresses
market thinking, and (3) it provides strong market evi-
dence of value when adequate sales are available.
1. David C. Lennhoff, “Direct Capitalization: It Might Be Simple But It Isn’t That Easy,” The Appraisal Journal (Winter 2011): 66-73.
Direct capitalization is applied using one of two basic methods:
• Applying an overall capitalization rate or multiplier to relate value to the entire prop-
erty income (e.g., net operating income)
• Using residual techniques that consider components of a property’s income and
then applying market-derived capitalization rates to each income component
analyzed (RL, RB, etc.)
Direct capitalization is distinct from yield capitalization (which is discussed in Chapters
26 and 27) in that it does not explicitly consider individual cash flows beyond one year.
Yield capitalization explicitly calculates the year-by-year effects of potentially changing
income patterns, changes in the original investment’s value, and other considerations. In
contrast, direct capitalization processes a single year’s income into an indication of value.
Either direct capitalization or yield capitalization can be used to produce a supportable
indication of value when based on relevant market information derived from compara-
ble properties. These comparable properties should have similar property rights, income-
expense ratios, land value-to-building value ratios, risk characteristics, occupancy or
vacancy levels, and future expectations of income and value changes over a typical pro-
jection period. The choice of capitalization method does not affect the indication of value.
Derivation of Overall Capitalization Rates

The overall interest in real estate that is capable of generating income can be valued
using direct capitalization. The direct capitalization formula is
Value =
Overall Capitalization Rate
Overall capitalization rates can be estimated with various techniques. The techniques
used depend on the quantity and quality of data available. When supported by ap-
propriate market data, accepted techniques include
• Derivation from comparable sales
• Band of investment—mortgage and equity components
• Band of investment—land and building components
• Debt coverage analysis
• Analysis of yield capitalization rates (the property model)
• Surveys
Derivation of RO from Comparable Sales

Deriving capitalization rates from comparable sales is the preferred technique when
sufficient information about sales of similar, competitive properties is available. Data
on each property’s sale price, income, expenses, financing terms, and market condi-
tions at the time of sale is needed. In addition, appraisers must make certain that the
net operating income of each comparable property is calculated and estimated in the
same way that the net operating income of the subject property is estimated.
Often the operating data available for comparable sale properties is from the year
that ended just prior to the date of sale, so appraisers may have to account for chang-
es that have occurred over time. Both income and expense data (in the 12 months
after the date of valuation) and the structure of expenses in terms of replacement
allowances and other components should be similar to those of the subject property.

Moreover, neither non-market financing terms, different market conditions, nor dif-
ferent property rights should have affected the prices of the comparable properties. If
the objective of the appraisal is to value the fee simple estate, market rent and terms
must be used or adjustments will be necessary. Capitalization rates from leased prop-
erties provide capitalization rates for the leased fee, not the fee simple. If the value
of the leased fee is being sought, the comparable properties should be leased in the
same manner as the subject property, or again adjustments will be required. Expecta-
tions for changes in the income and value of the comparable properties should also
match those of the subject property, or an adjustment to the rate will be necessary.
The overall level of risk associated with each comparable should be similar to
that of the subject property. Risk can be analyzed by investigating the credit rating of
the property’s tenants, market conditions for the particular property, the stability of
the property’s income stream, the level of investment in the property by the tenant,
the property’s net income ratio, and the property’s upside or downside potential. In
some property types, bonded leases are provided when the full faith and credit of the
tenant company guarantees the lease. This is common in sale leasebacks or build-to-
suit leases and results in leases with significantly reduced risk to the purchasers, and
therefore may affect rents and capitalization rates caused by the reduced risks.
When these requirements are met, an appraiser can estimate an overall rate by
dividing each property’s net operating income by its sale price. Table 25.1 illustrates
this procedure using data from four comparable sales of small residential income
properties. If all four transactions are equally comparable, the appraiser might con-
clude that an overall rate of 0.0941 to 0.0984 should be applied to the subject prop-
erty. The final rate concluded depends on the degree of similarity between each sale
and the subject property. For example, if Sales A and D are the most comparable, the
concluded rate might be approximately 0.0960, or 9.6%.
Table 25.1 Derivation of Overall Capitalization Rates from Comparable Sales

Sale A Sale B Sale C Sale D
Net operating income $35,100 $40,000 $30,500 $48,400
Price $368,500 $425,000 $310,000 $500,000
Indicated RO 0.0953 0.0941 0.0984 0.0968
If differences between a comparable property and the subject property that could
affect the selection of the overall capitalization rate are concluded, an appraiser must
account for these differences. In that case, the appraiser must decide whether the rate
selection for the subject property should be higher or lower than the rate indicated
by a specific sale or group of sales. Appraisal judgment is also needed to determine
whether the rate selected for the subject should fall within the range established by
the sales or be set above or below the range. If there are wide differences between a
comparable property and the subject property that could affect the overall capital-
ization rate, the appraiser must be able to explain the market behavior or property
elements that account for these differences.
When rates derived from comparable sales are used, the capitalization rate is
applied to the subject property in a manner consistent with its derivation. In other
words, if the market-derived capitalization rates are based on the properties’ net

operating income expectancies for the first year—i.e., the 12 months after the date of
sale—the capitalization rate for the subject property should be applied to its antici-
pated net operating income for the first year of operation.
The net income to be capitalized may be estimated before or after an annual al-
lowance for specific replacement categories, e.g., the allowance for furniture, fixtures,
and equipment for hotel properties and the replacement allowance for office proper-
ties.2 Again, it is imperative that appraisers analyze comparable sales and derive their
capitalization rates in the same manner used to analyze the subject property and
capitalize its income.
The following examples illustrate the importance of deriving and applying rates
consistently. In the first example, the replacement allowance for the subject property is
estimated to be $2,500. The overall rate indicated by comparable sales, in which a re-
placement allowance is not deducted as an operating expense, is 0.0850. In the second
example, the replacement allowance is deducted as an operating expense, and the
indicated overall rate is 0.0825. In the first calculation, the allowance is not included
as an expense item for the subject property, so the net operating income there is $2,500
higher than in the second calculation. The valuation conclusions produced by the two
calculations are identical because the rates were derived and applied consistently.
Allowance for Replacements Not Included in Operating Expenses
Net operating income $85,000
Overall rate 0.0850
Capitalization: $85,000/0.0850 $1,000,000
Allowance for Replacements Included in Operating Expenses
Overall rate 0.0825
Capitalization: $82,500/0.0825 $1,000,000
Criteria for Supporting Overall Capitalization Rates

An overall capitalization rate provides compelling evidence of value when a series of conditions are met:
1. Data should be drawn from properties that are physically similar to and have similar property rights as the
subject property and that are from similar (preferably competing) markets as the subject property. When a
comparable property has significant differences, it may be afforded little or no weight.
2. Sale properties used as sources for calculating overall capitalization rates should have current date of sale
and future market expectations, including income and expense patterns and likely value trends, that are
comparable to those affecting the subject property.
3. Income and expenses must be estimated on the same basis for the subject property and all comparable
properties. For example, if reserves for replacement are included in the net operating income for each compa-
rable, reserves for replacement should also be reflected in the net operating income for the subject property.
4. The comparable property’s price should reflect market terms, or an adjustment for cash equivalency must
be made.
5. If other adjustments are considered necessary to account for differences between a comparable property
and the subject property such as leasing commissions, tenant improvements, or deferred maintenance,
they should be made separately from the process of calculating the overall capitalization rate and should
be based on market evidence.
2. In some markets, practitioners do not deduct a replacement allowance as an above-the-line item in direct capitalization. Whenever this expense
item is implicit in the capitalization rate, it should not be deducted in estimating the net operating income for a subject property.

Whether net operating income is estimated with or without an allowance for replace-
ments, the overall capitalization rate is calculated by dividing the net operating
income of a comparable property by its sale price.
Derivation of RO by Band of Investment—Mortgage and Equity

Because most properties are purchased with debt and equity capital, the overall capi-
talization rate must satisfy the market return requirements of both investment posi-
tions. Lenders must anticipate receiving a competitive interest rate commensurate with
the perceived risk of the investment or they will not make funds available. Lenders
generally require that the loan principal be repaid through periodic amortization pay-
ments. Similarly, equity investors must anticipate receiving a competitive equity return
commensurate with the perceived risk, or they will invest their funds elsewhere.
The mortgage capitalization rate (RM) is the ratio of the annual debt service to the
principal amount of the mortgage loan:
Annual Debt Service
RM =
Mortgage Principal
For example, a $500,000 mortgage loan with annual debt service of $35,000 would
have a mortgage capitalization rate of 7% ($35,000/$500,000). The rate established at
the inception of a mortgage is commonly called the mortgage constant. The annual
mortgage constant for a new loan is calculated by multiplying each period’s payment
by the number of payments per year and then dividing this amount by the amount
of the loan. A current mortgage capitalization rate may also be calculated on the basis
of the outstanding mortgage amount once debt service payments have been made. It
should be noted that the mortgage capitalization rate (RM) differs from the yield rate
to the mortgage (YM). The yield rate to the mortgage is the internal rate of return that
equates the present value of the mortgage payments with the principal balance of the
loan—i.e., the rate used to calculate the mortgage payment.
The mortgage capitalization rate is a function of the interest rate, the frequency of
amortization (e.g., annual, monthly), and the amortization term of the loan. It is the
sum of the interest rate and the sinking fund factor. When the loan terms are known,
the mortgage capitalization rate can be calculated, using a financial calculator or any
of a variety of computer software programs, or by simply dividing the annual debt
service by the outstanding mortgage balance, if known.
The equity investor also seeks a systematic cash return. The rate used to capi-
talize equity income is called the equity capitalization rate (RE). It is the ratio of the
annual return to the equity position to the amount of equity investment. The equity
capitalization rate may be more or less than the expected equity yield rate (YE). For
appraisal purposes, a property’s equity capitalization rate is the anticipated cash flow
to the equity investor for the first year of the projection period divided by the initial
equity investment.
The overall capitalization rate must satisfy both the mortgage capitalization rate
requirement of the lender and the equity return requirement of the equity investor.
For mortgage-equity analysis, it can be viewed as a composite rate, weighted in pro-
portion to the total property investment represented by debt and equity. The overall
capitalization rate is a weighted average of the mortgage capitalization rate (RM) and
equity capitalization rate (RE). The loan-to-value ratio (M) represents the loan or debt
portion of the property investment. The equity ratio (E, which is sometimes shown as

1 - M) represents the equity portion of the property investment. The sum of E and M
is 1, i.e., 100%.
When sufficient market data is available, the overall rate can be calculated
directly. This method is not a substitute for using rates extracted from the market if
they are available. If only the mortgage and equity capitalization rates are known,
however, an overall rate may be derived with the band-of-investment, or weighted-
average, technique. The following formulas are used to calculate the overall capital-
ization rate:
Mortgage component M × RM =
Equity component + E × RE = +
RO =
To illustrate how the overall capitalization rate is calculated with the band-of-invest-
ment technique, suppose that the following characteristics describe the subject property.
Available loan 75% ratio, 7.0% interest, 25-year amortization period
(monthly payment), 8.5% mortgage capitalization rate (RM)
Equity capitalization rate 6.5% (derived from comparable sales)
The overall rate is calculated as follows:

RO = (M × RM) + (E × RE) = (0.75 × 0.085) + (0.25 × 0.065) = 0.06375 + 0.01625 = 0.08000
Although this technique can be used to derive overall capitalization rates, the
technique is only applicable when sufficient market data is available to estimate equity
capitalization rates. A capitalization rate used to develop an opinion of market value
should be justified and supported by market data, but sometimes this data is not avail-
able. When the available market data is scarce or not reliable, mortgage-equity tech-
niques may be used to develop or test capitalization rates. Appraisers may develop
information through interviews with market participants and from their own records.
These indirect analyses are not substitutes for data from market sales of comparable
properties, but they can lead to valuable insights and understandings. The mortgage
yield rate (YM) should not be used in place of the mortgage capitalization rate (RM), nor
should an equity yield rate (YE) be substituted for an equity capitalization rate (RE).
Derivation of RO by Band of Investment—Land and Building

A band of investment formula can also be applied to the physical components of
property—i.e., the land and the buildings. Essentially this methodology is the same
as the mortgage-equity technique, except that the elements are the physical property
components. Just as weighted rates are developed for mortgage and equity compo-
nents in mortgage-equity analysis, weighted rates for the land and buildings can be
developed if accurate rates for these components can be estimated independently
and the proportion of total property value represented by each component can be
identified. The formula is
RO = (L × RL) + (B × RB)
where
L = land value as a percentage of total property value
RL = land capitalization rate
B = building value as a percentage of total property value
RB = building capitalization rate

As an example, assume the land represents 45% of the value of a property and
the building represents the other 55%. The land capitalization rate derived from com-
parable sales data is 8.0%, and the building capitalization rate is 11.0%. The indicated
overall rate is calculated as follows:
RO = (L × RL) + (B × RB) = (0.45 × 0.08) + (0.55 × 0.11) = 0.0360 + 0.0605 = 0.0965
Land and building capitalization rates may be extracted by applying residual analy-
sis to improved properties. (Land and building residual techniques are illustrated
later in this chapter.)
Debt Coverage Formula

In addition to the traditional terms of lending—i.e., the interest rate, loan-to-value ra-
tio, amortization term, maturity, and payment period—real estate lenders sometimes
use another judgment criterion: the debt coverage ratio (DCR).3 This is the ratio of net
operating income to annual debt service (IM), or the payment that covers interest on
and retirement of the outstanding principal of the mortgage loan:
I
DCR = O
IM
When lenders underwrite loans on income-producing property, they try to pro-
vide a cushion so that the borrower will likely be able to meet the debt service obliga-
tions on the loan even if property income declines. Lenders establish a debt coverage
ratio as a matter of policy, which must be greater than 1.0 to cover debt service. More
risky loans require a higher debt coverage ratio. For example, if a ratio of 1.20 is typi-
cal, a more risky loan may require a ratio of 1.50.
The debt coverage ratio can be multiplied by the mortgage capitalization rate and
the loan-to-value ratio to arrive at an estimated overall rate for a property that is at
stabilized occupancy. Lenders sometimes refer to overall capitalization rates devel-
oped using this method as in-house capitalization rates. The formula is
RO = DCR × RM × M
For a property with net operating income of $50,000 and annual debt service of
$43,264, the debt coverage ratio is calculated as
$50,000
DCR = = 1.1557
$43,264
If RM equals 0.085 and M is 0.75, RO is estimated as
RO = 1.1557 × 0.085 × 0.75 = 0.0737
Debt coverage ratio analysis is sometimes used as a check or test of reasonableness
for a capitalization rate derived using another method.
Surveys
Various national real estate and research firms survey institutional investors periodical-
ly and publish the discount and capitalization rate requirements of those investors. The
results of these surveys can give appraisers an overall picture of current return require-
ments (in contrast to historical performance data). Many appraisers survey investors
and other market observers in their local markets to augment secondary survey data.
3. James H. Boykin and Martin E. Hoesli, “An Argument for the Debt Coverage Method in Developing Capitalization Rates,” The Appraisal Journal
(October 1990): 558-566.

In the development of a capitalization rate, surveys are generally used as sup-
port rather than as primary evidence of a capitalization rate. Survey data obtained
directly from subscription services often contains more comprehensive information
about investment criteria and trends than information published in the trade press.4
In judging the reliability of capitalization rate survey data, an appraiser may consider
the following:
• The number and composition of survey participants
• The geographical location of each sector of the real estate market covered by the
survey
• The category or product, grade or quality, and locational attributes of each sector
of the real estate market surveyed
• How the measures of financial performance such as overall capitalization rates
are derived
• Whether reserves for replacement are included for RO survey data
• The fact that surveys almost always represent leased fee capitalization rates
Appraisers who use rates published in national surveys should understand that
the participants in the surveys may not represent typical real estate investors. Often
these surveys reflect the opinions of institutional investors such as insurance compa-
nies, pension funds, and other high-wealth equity investors. These investors likely
will not have the same investment criteria as typical investors in small commercial
and residential properties.
Residual Techniques
Residual techniques are based on the same premises that apply to direct capitaliza-
tion rates. However, while an overall rate processes the entire net operating income
into a value indication, the residual techniques separate net operating income into
various components. These include the income attributable to physical components
(land and building residuals), financial components (mortgage and equity residuals),
and legal components (leased fee and leasehold estates). Although these components
can be appraised by applying yield capitalization techniques, in direct capitalization
only the first year’s net operating income for each component is expressly included
in the analysis. The application of residual techniques is only appropriate if the infer-
ences on which the techniques are based are reasonable.
Regardless of which known and unknown (residual) components of the property
are being analyzed, an appraiser starts with the value of the known items and the net
operating income, as shown in Table 25.2. To apply a residual technique, an appraiser
performs the following steps:
1. Apply an appropriate capitalization rate to the value of the known component to
derive the annual income needed to support the investment in that component.
2. Deduct the annual income needed to support the investment in the known com-
ponent from the net operating income to derive the residual income available to
support the investment in the unknown component.
4. Tony Sevelka, “Where the Overall Cap Rate Meets the Discount Rate,” The Appraisal Journal (Spring 2004): 135-146.

3. Capitalize the residual income at a capitalization rate appropriate to the invest-
ment in the residual component to develop the present value of this component.
4. Add the values of the known component and the residual component to derive a
value indication for the total property.
Table 25.2 Known and Unknown Variables in Residual Calculations

Residual Technique Known Unknown
Land residual Net operating income (NOI or IO) Land or site value (VL)
Building value (VB)
Building capitalization rate (RB)
Land capitalization rate (RL)
Building residual Net operating income (NOI or IO) Building value (VB)
Land or site value (VL)
Land capitalization rate (RL)
Building capitalization rate (RB)
Mortgage residual Net operating income (NOI or IO) Mortgage amount (VM)
Amount of equity (VE)
Equity capitalization rate (RE)
Mortgage capitalization rate (RM)
Equity residual Net operating income (NOI or IO) Amount of equity (VE)
Mortgage amount (VM)
Mortgage capitalization rate (RM)
Equity capitalization rate (RE)
Residual techniques allow an appraiser to capitalize the income allocated to an

investment component of unknown value after other investment components of
known value have been satisfied. They can be applied to the land and building com-
ponents of property, to the mortgage and equity components, to the leased fee and
leasehold components (but only when specific property information is available), or
to the income and reversion components.
Prior to the publication of The Ellwood Tables in 1959, the physical residual tech-
niques (land and building) were the dominant methods for valuing real estate. L. W.
Ellwood’s contribution to the income capitalization approach changed the practice of
real estate appraisal in several ways:
• Prior to The Ellwood Tables, appraisers generally considered all market value
transactions to reflect cash transfers between the buyer and the seller with no
provision for financing. Ellwood recognized that most market transactions
involved cash to the seller but were financed in part with some form of debt or
other financial consideration on the part of the buyer. His view was that each
component—mortgage and equity—could be analyzed separately in the context
of a given property.
• Ellwood promoted the simple understanding that choosing an alternate meth-
od—direct capitalization or yield capitalization—did not produce a different
result. As long as market rates appropriate to the method were applied, the same
result would be produced.

• Ellwood emphasized that the concept of the present worth of anticipated future
benefits provides that if it is possible to construct a cash flow statement for any
given time horizon, it is possible to use some form of discounting in the capital-
ization process. This realization permitted appraisers and investors to consider
the anticipated benefits of a given property more precisely and to avoid using
direct capitalization to analyze a single year’s income, which might be less pre-
cise. Ellwood stated that “two years are better than just one” and even a five-year
analysis is feasible for most income-producing properties.
• Until The Ellwood Tables, most appraisers focused on land and building compo-
nents. Ellwood added the consideration of mortgage and equity components to
provide another dimension to the analysis, not as a substitute.
• Ellwood did not limit his thinking to market value alone. Instead he provided
an analytical framework in which specific anticipations or market expectations
could be tested and the results applied to either opinions of market value or
other aspects of property financial analysis.
• Although Ellwood is most often credited with adding new considerations to real
property appraisal analysis, he also clarified, refocused, and brought new under-
standing to the fundamental appraisal methods and techniques that had been
applied for many years. In this way, he helped overcome errors and abuses in
traditional appraisal practices and made the analysis more precise while adding
new techniques.
The development of computerized discounted cash flow analyses in profes-
sional appraisal practice has largely supplanted the use of residual techniques, except
when the data needed to apply more sophisticated techniques is not available. Today
residual techniques are used primarily in specialized situations—e.g., in highest
and best use analysis as a test of financial feasibility. Nevertheless, residual analysis
techniques remain a fundamental component of appraisal theory, and well-rounded
appraisers should be familiar with them.
Building Residual Technique

An appraiser who applies the building residual technique must be able to estimate
land value independently. The technique is especially applicable when data on land
values and land rents is available to establish land capitalization rates. An appraiser
applies the land capitalization rate to the known land value to obtain the amount of
annual net income needed to support the land value. Then this amount is deducted
from the net operating income to derive the residual income available to support the
investment in the building (or buildings). The appraiser capitalizes this residual in-
come at the building capitalization rate to derive an indication of the present value of
the building (or buildings). Finally, the land value and the building value are added
to derive an indication of total property value.
For example, consider a small warehouse with an estimated land value of
$200,000. Analysis of several sales of comparable sites reveals a land capitalization
rate of 6.5% and a building capitalization rate of 10%. The net operating income of
the subject property is estimated to be $67,500. Using the building residual technique,
the value of the subject property is calculated as follows:

Estimated land value $200,000
Less income attributable to land
Land value × RL ($200,000 × 0.065) - $13,000
Residual income to building $54,500
Building value (capitalized: $54,500 ÷ 0.10) + $545,000
Indicated property value $745,000
This technique is simple, but its applicability and usefulness are extremely limited.
Depending on the particular market, the building residual technique may or may
not reflect the way purchaser-investors regard investment real estate. However, if
the required data is available, the building residual technique can be used to value
properties with improvements that have suffered substantial depreciation. In fact,
current reproduction or replacement cost minus the present value of the improve-
ments provides an estimate of total depreciation. In addition, the building residual
technique directly measures the contribution of the improvements to total property
value, so it can help an appraiser determine when demolition or major renovation of
property improvements is economically feasible or, if appropriate, help establish the
tax basis for depreciation of the improvements.
Land Residual Technique

The land residual technique calls for a separate estimation of the value of the build-
ing (or buildings). In land residual applications, an appraiser will often consider a
new highest and best use assuming a building that does not exist. In this application,
building value is usually estimated as the current cost to construct a new building
that represents the highest and best use of the site.
The building capitalization rate is applied to the building value to obtain the
amount of annual net income needed to support the value of the building. This amount
is then deducted from net operating income to indicate the residual income available
to support the investment in the land. The residual income is capitalized at the land
capitalization rate to derive an indication of the value of the land. Finally, the building
value is added to the land value to derive an indication of total property value.
Using the same data used in the building residual example but assuming that
building value rather than land value is known, the problem is calculated from the
opposite viewpoint. The land and building capitalization rates derived from the mar-
ket are applied to the subject property as follows:
Estimated building value $545,000
Less income attributable to the building
Building value × RB ($545,000 × 0.10) - $54,500
Residual income to land $13,000
Land value (capitalized: $13,000 ÷ 0.065) + $200,000
The land residual technique allows an appraiser to estimate land values when
recent data on land sales is not available. In practice, the technique is used often to
test the highest and best use of the land or site for proposed construction. The land re-

sidual technique is less applicable when the cost to produce a new building is incon-
sistent with the amount of value such a building would contribute to property value.
Land and building residual techniques should be used with extreme care because
small changes in the assumptions made can often have a significant influence on
value indications.
Equity Residual Technique

To apply the equity residual technique, an appraiser deducts annual debt service from
net operating income to obtain the residual income to the equity interest. The annual
debt service is calculated based on mortgage loan terms typically available in the market.
To derive an equity capitalization rate from the market, appraisers may apply the
following process:
Less mortgage debt service
$375,000 loan, 5.0% interest, 25-year term
$375,000 × 0.07015* = - $26,307
Residual income to equity $18,693
Equity investment (known) $212,000
Equity capitalization rate
$18,693 ÷ $212,000 8.82%
* Annual constant (RM) for monthly loan payment from precomputed tables. A financial calculator or computer can also be used to
calculate the annual constant.
For a similar property with comparable characteristics, the 8.82% equity capital-
ization rate can be divided into the equity income to develop an indication of equity
value. When equity value is added to the mortgage amount, an indication of prop-
erty value is produced. The results derived in applying the equity residual technique
can also be used in the band-of-investment method.
Mortgage Residual Technique

When the mortgage residual technique is applied, the amount of available equity is the
known component and the mortgage amount or value is unknown. The income need-
ed to satisfy the equity component at the equity capitalization rate is deducted from the
net operating income to obtain the residual income to the mortgage component. The
residual mortgage income is then capitalized into value at the mortgage capitalization
rate. The preceding example of equity residual capitalization can be approached from
the opposite side of the equation to illustrate mortgage residual technique calculations:
Available equity $212,000
Less equity requirement
Equity × RE ($212,000 × 0.0882) - $18,693
Residual income to mortgage $26,307
Mortgage value
(capitalized: $26,307 ÷ 0.07015) + $375,000
The mortgage residual technique works as a mathematical process, but it does

not follow the customary logic of market participants. Its most common use is in

determining the amount of mortgage available and the associated value requirement.
For example, an investor with a certain amount of equity and a given set of mort-
gage terms could apply the mortgage residual technique to determine how much to
pay for a property. However, the technique is based on the premise that the amount
of money the equity investor is willing to invest in the property has already been
determined and that the investor requires a specified equity capitalization rate from
the property. This implies that the loan amount depends on the residual cash flow
available for mortgage debt service and the mortgage capitalization rate. Lenders
generally will not make a loan unless net operating income exceeds the mortgage
debt service by a specified amount. Also, once the loan is made, the lender has the
legal right to receive the agreed-upon debt service, but any residual cash flow goes to
the equity investor. Even with below-market loans, the equity investor receives the
income remaining after payment of the contract interest. Thus, the mortgage residual
technique does not necessarily reflect market behavior and would not normally be
appropriate for estimating the value of a property subject to a specific mortgage.
Leased Fee and Leasehold Residuals

Theoretically, the leased fee and leasehold components of value can be derived us-
ing residual techniques, although the assumption that the sum of the values of the
leasehold and the leased fee equals the value of the fee simple estate has not histori-
cally been supported by market data. As a result, leased fee and leasehold residuals
are of dubious usefulness. The remaining term of a lease, the creditworthiness of the
tenants, the influence of atypical lease clauses and stipulations, and other factors can
affect the value of the sum of the parts, causing the sum to be greater or less than the
value of the fee simple, sometimes significantly so.
The value of the leased fee represents the owner’s interest in the property. The
benefits that accrue to an owner of a leased fee generally consist of income through-
out the lease term and the reversion at the end of the lease.
The market value of a leasehold depends on how contract rent compares to mar-
ket rent, as shown in Figure 25.1. A leasehold may acquire value if the lease allows
for subletting or assignment and the remaining term is long enough so that market
participants will pay something for the advantageous lease.
When analyzing a leasehold, it is essential that appraisers analyze all of the
economic benefits or disadvantages created by the lease. An appraiser should ask the
following questions:
• What is the term of the lease?
• What is the likelihood that the tenant will be able to meet all of the rental pay-
ments on time?
• Are the various clauses and stipulations in the lease typical of the market, or do
they create special advantages or disadvantages for either party?
• Is the leasehold transferable, or does the lease prohibit transfers?
• Is the lease written in a manner that will accommodate reasonable change over
time, or will it eventually become cumbersome to the parties?
A residual calculation of the value of a leasehold or leased fee is least often ap-
propriate in the case of an above-market or below-market lease. When the value indi-
cation derived serves as an indication of the value of the fee simple, and subtracting

Figure 25.1 Negative and Positive Leaseholds
Excess
Rent
Market
Rent
Deficit
Rent
Contract
Rent
Contract
Rent
Negative Leasehold Positive Leasehold

Contract Rent Contract Rent
above Market Rent below Market Rent
the capitalized rent loss allows the value indication to be allocated between leased fee
and leasehold components. Alternatively, the sales comparison approach can be used
to estimate the value of the leased fee if the comparable sales have similar above- or
below-market rates and are therefore already value indications for leased fee. Simi-
larly, leased fee capitalization rates can be extracted from comparable sales with
similar above- or below-market rents.
Using direct capitalization techniques to value a leased fee, an above- or below-
market contract rent can be capitalized at a leased fee capitalization rate derived
from comparable sales with similar above- or below-market lease characteristics. Or
the market rent can be capitalized using a rate derived from comparable sales with
market-rate (or near-market) leases, and the value indication can be adjusted for the
above- or below-market lease.
Leasehold capitalization rates are difficult to derive and can be sensitive to lease
characteristics. As a result, leaseholds are usually valued using discounted cash flow
analysis instead of direct capitalization.
Appraisers cannot simply assume that each of the interests created by a lease
has market value. Many leases create no separate value for the tenant. For example,
a leasehold may not be a marketable interest because the lease terms do not allow
for subleasing, so that the holder of the leasehold (i. e., the tenant) does not have
the opportunity to take advantage of a below-market rent in the marketplace. Also,
the market value of a leased fee can be sensitive to lease terms other than the rate.
The analysis of the risk associated with a leasehold may differ significantly from the
analysis of risk of the leased fee. Leasing terms that may be considered high risk to

the landlord may be considered low risk to the tenant. As an example, consider a
renewal option to a tenant that is available at below-market rent. Tenants may look at
the option to renew at a below-market rate as a benefit, whereas discounting may be
inappropriate from their perspective.
Gross Income Multipliers and Gross Rent Multipliers

Gross income multipliers (GIMs) are direct capitalization techniques used to compare
the income-producing characteristics of properties, most often small residential in-
come properties. Potential or effective gross income can be converted into an opinion
of value by applying the relevant gross income multiplier. This method of capitaliza-
tion is mathematically related to direct capitalization because rates are the reciprocals
of multipliers or factors. Therefore, it is appropriate to discuss the derivation and use
of multipliers under direct capitalization.
To derive a gross income multiplier from market data, sales of properties that
were rented at the time of sale or were anticipated to be rented within a short time
must be available. The ratio of the sale price of a property to its anticipated next
year’s income or its projected income over the first year of ownership is the gross in-
come multiplier. Gross income multipliers are typically calculated on an annual basis.
The derivation and application of gross income multipliers for valuation pur-
poses must be performed with care for several reasons. First, the properties analyzed
must be comparable to the subject property and to one another in terms of physical,
locational, and investment characteristics. Properties with similar or even identical
multipliers can have very different operating expense ratios and, therefore, may not
be comparable for valuation purposes.
Second, the term gross income multiplier is used because some of the gross income
from a property or type of property may come from sources other than rent. A gross
rent multiplier applies to rental income only and can be calculated on a monthly or
annual basis, consistent with market practices.
Third, an appraiser must use similar income data to derive the multiplier for each
transaction. For example, gross income multipliers extracted from full-service rentals
would not be applied to a subject property leased on a net basis. The sale price can
be divided by either the potential or effective gross income, but the data and mea-
sure must be used consistently throughout the analysis to produce reliable results.
Different income measures may be used in different
valuation studies and appraisals. The income measure
selected is dictated by the availability of market data, The application of income
the purpose of the analysis, the effective gross income multipliers is a direct
capitalization procedure. In
multiplier, and the net income multiplier. developing an income or
Experienced appraisers understand that gross rent multiplier, it is essential
income multipliers and effective gross income that the income or rent of
multipliers are sensitive valuation tools. Small the properties used to derive
differences in each may have a great effect on the the multiplier be comparable
to that of the subject and
resulting value indications. that the specific multiplier
To illustrate the difference between various gross derived be applied to the
income multipliers, the following calculations are made same income base.
using the data for Sale A shown in Table 25.1. Note that

in this case, the potential gross income for Sale A is indicated to be $85,106 and the
effective gross income is $80,000.
Sale Price $368,500
Potential Gross Income Multiplier = = = 4.33 (rounded)
Potential Gross Income $85,106
Sale Price $368,500
Effective Gross Income Multiplier = = = 4.61 (rounded)
Effective Gross Income $80,000
After the gross income multiplier is derived from comparable market data, it
must be applied on the same basis it was derived. In other words, an income mul-
tiplier based on effective gross income can only be applied to the effective gross in-
come of the subject property. Similarly, an income multiplier based on potential gross
income can only be applied to the potential gross income of the subject property. The
timing of income also must be comparable. If sales are analyzed using next year’s
income expectation, the multiplier derived must be applied to next year’s income
expectation for the subject property.

Yield Capitalization 26
Yield capitalization is the more complex of the two fundamental methods used in the
income capitalization approach to value. Within these methods, various techniques
are available for converting a series of future cash flows received over time into an
indication of value.
Yield capitalization is used to convert explicit future economic benefits into an
indication of present value by applying an appropriate discount rate. To select an
appropriate discount rate for a market value appraisal, an appraiser analyzes market
evidence of the yields anticipated by typical investors, supported by market sales
data, or both. When investment value is sought, the discount rate used should reflect
the individual investor’s requirements, which may differ from the requirements of
typical investors in the market.
To perform yield capitalization, an appraiser
1. Selects an appropriate projection period
2. Forecasts all explicit future economic benefits or cash flow patterns (including the
reversion, if any)
3. Chooses an appropriate yield or discount rate
4. Converts explicit future economic benefits into present value by discounting
each annual future benefit to present value or by developing an overall rate that
reflects the income pattern, value change, and yield or discount rate using one of
the various yield capitalization formulas
The application of capitalization rates that explicitly reflect an appropriate yield
rate, the use of present value factors, and discounted cash flow analysis are all yield
capitalization procedures. Mortgage-equity formulas and yield rate or value change
formulas may be used to derive overall capitalization rates.
Like direct capitalization, yield capitalization should reflect market behavior.
To apply the discounting procedure, appraisers must be familiar with the following
concepts and techniques:
• Income patterns
• Capital return concepts
• The mathematics of the discounting process
• Investor requirements or expectations—i.e., projection period, anticipated market
changes, and inflation or deflation
• The selection of an appropriate discount rate
Discounting
Discounting is a general term used to describe the process of converting future cash
flows into a present value. The discount rate is the rate used for the discounting
process and may be a property yield rate, equity yield rate, or some other defined
rate. In real estate appraisal practice, the most common method for valuing the total
bundle of rights (the fee simple) is the property yield rate (YO).
In the discounting process, periodic incomes and the reversion, if any, are con-
verted into present value through discounting, which is based on the concept that
benefits received in the future are worth less than the same benefits received today.
The return on an investment compensates the investor for foregoing present bene-
fits—i.e., the immediate use of capital—and accepting future benefits and risks. This
return is usually called interest by lenders and yield by property owners and equity
investors. The discounting procedure includes the expectation that the return of capi-
tal will be accomplished through periodic income, the reversion, or a combination of
the two.
An investor seeks a total return that exceeds the amount invested. In order to
satisfy what the investor seeks, the present value of a prospective benefit must be less
than its expected future benefits. A future payment is discounted to present value by
calculating the amount that, if invested today, would grow with compound interest
at a satisfactory rate to equal the future payment. The standard formula for discount-
ing future value to present value is
Future Value
Present Value =
(1 + i)n
where i is the rate of return on capital per period (or the discount rate) that will
satisfy the investor (i.e., its opportunity cost) and n is the number of periods that the
payment will be deferred. If a series of future payments is expected, each payment is
discounted with the standard formula, and the present value of the payments is the
sum of all the present values.
In discounting calculations, the amount paid (e.g., a loan payment to a lender)
or received (e.g., a rent payment from a tenant) can be in the form of a single lump
sum, a series of periodic installments such as rental income, or a combination of both.
When income amounts are compounded or discounted, the rate used is the effec-
tive yield rate. On an annual basis, this rate is identical to the nominal yield rate. If
income amounts are compounded or discounted more often than annually—e.g.,
semiannually or monthly—the nominal yield rate is divided by the number of com-
pounding or discounting periods. For example, a nominal annual yield rate of 12% is
an effective yield rate of 6% for semiannual conversion periods, or an effective yield
rate of 1% for monthly conversions. Standard tables of factors, financial calculators,
and computers can be used to facilitate the application of factors, but the user must
select the appropriate compounding frequency—i.e., monthly, quarterly, or annually.

All present value problems consider the following:
1. The starting cost, value, or investment amount
2. The amount and timing of the periodic cash flows over time
3. The reversion or resale value
4. The yield rate that equates the cash flows and reversion to the starting value1
5. The amount of time (number of periods) between the initial cash flow and the
reversion
Because each individual cash flow is considered separately, a discounted cash
flow (DCF) analysis can be used to solve any problem when three of the five factors
are known.
In discounted cash flow analysis, the yield formula is expressed as
CF1 CF2 CF3 CFn
PV = + + + … +
1 + Y (1 + Y)2 (1 + Y)3 (1 + Y)n
where
PV = present value
CF = the cash flow for the period specified
Y = the appropriate periodic yield rate
n = the number of periods in the projection
This standard discounting procedure is the foundation for all present value calculations.2
In DCF analysis, the quantity, variability, timing, and duration of cash flows are
specified. In the formula, cash flow refers to the periodic income attributable to the in-
terests in real estate. Each cash flow is discounted to present value and all the present
values are totaled to obtain the value of the real property interest being appraised.
The future value of that interest—the reversion—is forecast to occur at the end of the
projection period and is also discounted. The cash flows discounted with the DCF
process may be the net operating income to the entire property or the cash flows to
specific interests—e.g., the cash flows to the equity interest (equity dividends) or debt
service for the mortgage interest.
With the DCF process an appraiser can discount each payment of income and
the reversion separately and add all the present values together to obtain the present
value of the property interest being appraised. The formula treats the reversion as a
cash flow that can be valued separately from the income stream. The formula can be
used to develop opinions of
• Total property value (VO)
• Loan value (VM)
• Equity value (VE)
• Leased fee value (VLF)
• Leasehold value (VLH)
• The value of any other interest in real estate
1. In discounted cash flow analysis, a discount rate is usually an input. The terms tend to be used synonymously, but there is a subtle difference. A
discount rate is applied to an income stream to calculate present value. That is, the income stream and discount rate are known, while PV is the
unknown variable that is solved for. A yield rate is the rate that equates an income stream to a present value. In other words, the present value
and income stream are known, whereas the yield rate is the unknown that is solved for.
2. For formulas, tables, and sample applications of the six functions of one, see Appendix C.

Projection Period and Holding Period
The holding period of an investment is defined as the term of ownership of the investment, whereas the projec-
tion period is a presumed period of ownership for analysis and valuation purposes. In other words, the projection
period is a period of time over which expected cash flows are forecast for the purposes of analysis and valuation.
Although these terms are often used interchangeably, appraisers are more often concerned with the projection
period applicable to the analysis in question. In some markets, the term designated investment period is used.
The projection period may vary with the investment and investor. An appraiser usually estimates a projec-
tion period that is consistent with investor expectations developed through surveys and interviews. In the
selection of an appropriate projection period, an appraiser should consider lease expirations, vacancies,
rollovers, anticipated capital improvements, and other atypical events that may cause cash flow aberrations.
Risk increases as the projection period of an investment increases for several reasons:
• Maintenance costs increase as a building ages.
• Remaining economic life declines as a building ages.
• Functional issues relating to competition from newer properties may force a property into a lower invest-
ment category.
• In general, as forecasts look farther into the future, the conclusions become less certain.
Cash flows further out are discounted more.
Any series of periodic incomes, with or without a reversion, can be valued with
the basic DCF formula. Various formulas are available for valuing level annuities and
increasing and decreasing annuities, which are introduced later in this chapter. These
formulas have two benefits. First, they can be used as shortcuts to solve for property
value, although if used as shortcuts they may be harder for an appraiser to explain
and for the client to understand. Second, and more importantly, they provide a sys-
tematic method to evaluate real estate and the interactions of current value, income
flows, and future value in a single problem-solving framework.
Most often financial calculators or computer programs are used to solve dis-
counting problems mathematically. To apply compounding or discounting proce-
dures, appraisers must know
• The basic formulas
• How the various factors relate to one another
• How they may be used or combined to apply yield capitalization and develop an
indication of value
Software programs and standardized tables and factors are useful in solving
various yield capitalization problems. However, in the final analysis, an opinion of
value and conclusions about time, amount, and yield reflect the appraiser’s judgment
based on appropriate research of the subject property and relevant market data.
Estimation of a Yield Rate for Discounting

The estimation of an appropriate discount rate is critical to DCF analysis. (A yield rate is
a generic term used to describe many rates. When anticipated cash flows are used, it is
called a discount rate. When actual past cash flows are used, it is called an internal rate
of return.) To select an appropriate discount rate, an appraiser must verify and interpret
the attitudes and expectations of market participants, including buyers, sellers, advis-
ers, and brokers. Although the actual yield on an investment cannot be calculated until
the investment is sold, an investor may set a target yield for the investment before or

during ownership. Historical yield rates derived from comparable sales may be rel-
evant, but they reflect past, not future, benefits in the mind of the investor and may not
be reliable indicators of the current required yield. Therefore, the estimation of yield
rates for discounting cash flows should focus on the prospective or forecast yield rates
anticipated by typical buyers and sellers of comparable investments. An appraiser can
verify investor expectations by interviewing the parties to comparable sales transactions
or reviewing marketing materials for comparable properties recently offered for sale.
An appraiser narrows the range of indicated yield rates and selects an appropriate
yield rate by comparing the physical, economic, financial, legal, and risk characteristics
of the comparable properties with the property being appraised and assessing the com-
petition for capital in rival investments. In some situations, there may be reason to select
a yield rate above or below the indicated range. The final estimation of a yield rate
requires judgment, just as an appraiser uses judgment to select an overall capitalization
rate or equity capitalization rate from the range indicated by comparable sales. In select-
ing a yield rate, an appraiser should analyze current conditions in capital and real estate
markets and the actions, perceptions, and expectations of real estate investors.
Different Rates
Discount rates are primarily a function of perceived risks. Different portions of
forecast future income may have different levels of risk and therefore different yield
rates.3 In lease valuation, for example, one rate might be applied to discount the se-
ries of net rental incomes stipulated in the lease, and a different rate might be applied
to discount the reversion, which is known as the split-rate method or bifurcated method.
One rate reflects the creditworthiness of the tenant as well as the benefits, constraints,
and limitations of the lease contract, while the other is subject to free, open-market
conditions. The decision to apply a single discount rate to all benefits or to apply dif-
ferent rates to different benefits should be based on investors’ actions in the market
and the method used to extract the yield rate. In all cases, these rates should be ap-
plied in the same way they were developed.
Income Stream Patterns

After specifying the amount, timing, and duration of the cash flows to the property
interest being appraised, an appraiser should identify the pattern that the income
stream is expected to follow during the projection period. These patterns may be
grouped into the following basic categories:
• Variable annuity (irregular income pattern)
• Level annuity
• Increasing or decreasing annuity
Variable Annuity: Nonsystematic Change

In a variable annuity, payment amounts may vary in each period. To value a variable
annuity, the present value of each income payment is calculated separately and these
3. When future events that could profoundly influence the income-producing potential of a property may or may not occur, probability analysis
may be appropriate. Probability analysis is frequently required when properties are subject to potential environmental hazards and compliance
with environmental regulations is pending. For example, a site may require an undetermined level of environmental remediation, the remediation
required may or may not be completed within a given time frame, or the environmental regulations governing the remediation may be modified.
In those situations, probability analysis can help an appraiser develop a yield rate.

The Nature of Annuities
Although the word annuity means an annual income, the term is used to refer to a program or contract specifying
regular payments of stipulated amounts. Payments need not be annual, but the interval between payments is usu-
ally regular. An annuity can be level, increasing, or decreasing, but the amounts must be scheduled and predict-
able. Income characterized as an annuity is expected at regular intervals and in predictable amounts. Obviously
real estate income or rental income can have the characteristics of an annuity. Monthly mortgage payments are per-
haps the best example of an annuity. The pattern of income expected from a real estate investment may be regular
or irregular. Various capitalization techniques have been developed to apply to a wide range of income patterns.
values are totaled to obtain the present value of the entire income stream. This proce-
dure is discounted cash flow analysis.
Any income stream can be valued as if it were a variable annuity. Level annuities
and annuities that change systematically are subsets or regular patterns of income
that can also be handled with special formulas that reflect the systematic pattern of
the income stream. These shortcut formulas can save time and effort in certain cases,
but valuing an income stream as a variable annuity with a calculator or computer
program may be easier and will result in the same conclusion.
Level Annuity
A level annuity is an income stream in which the amount of each payment is the
same. It is a level, unchanging flow of income over time. The payments in a level an-
nuity are equally spaced and regularly scheduled. Level annuities can be discounted
in the same manner as variable annuities. However, compound interest tables sim-
plify the calculation for level income patterns, while providing an identical result.
There are two types of level annuities:
• Ordinary annuities
• Annuities payable in advance
Ordinary Annuity
An ordinary annuity, which is the most common type of level annuity, is distinguished
by income payments that are received at the end of each period, often referred to as “in
arrears.” Standard fixed-payment mortgage loans, many corporate and government
bonds, endowment policies, and certain lease arrangements are ordinary annuities.
Annuity Payable in Advance

An annuity payable in advance is a level annuity in which the payments are received
at the beginning of each period. A lease that requires payments at the beginning of
each month, like most apartment leases, creates an annuity payable in advance.
Increasing or Decreasing Annuity

An income stream that is expected to change in a systematic pattern is either an
increasing annuity or a decreasing annuity. Appraisers encounter three basic patterns
of systematic change:
• Step-up and step-down annuities
• Straight-line (constant-amount) change per period annuities
• Exponential-curve (constant-ratio) change per period annuities

Step-Up and Step-Down Annuities
A step-up or step-down annuity is usually created by a lease contract that calls for a
succession of level annuities of different amounts to be paid in different periods of
the lease term. For example, a lease might call for monthly payments of $500 for the
first three years, $750 for the next four years, and $1,200 for the next six years. Over
the 13-year term of the lease, there are three successive level annuities—one for three
years, one for four years, and one for six years.
Straight-Line (Constant-Amount) Change per Period Annuity

An income stream that increases or decreases by a fixed amount each period fits
the pattern of a straight-line (constant-amount) change per period annuity. These
income streams are also called straight-line increasing or straight-line decreasing annui-
ties. For example, a property may have an estimated first-year net operating income
of $100,000 that is forecast to increase by $7,000 per year. Thus, the second year’s
net operating income will be $107,000, the third year’s net operating income will be
$114,000, and so forth. Similarly, the income stream of a straight-line decreasing an-
nuity is expected to decrease by a constant amount each period.
Exponential-Curve (Constant-Ratio) Change per Period Annuity

An income stream with an exponential-curve (constant-ratio) change per period is also
referred to as an exponential annuity. This type of income stream increases or decreases
at a constant ratio and therefore the increases or decreases are compounded. For
example, a property with an estimated first-year net operating income (IO) of $100,000
that is forecast to increase 7% per year over each preceding year’s cash flow will have
an IO in the second year of $107,000 ($100,000 × 1.07). However, the third year’s IO will
be $114,490 ($107,000 × 1.07) and the fourth year’s IO will be $122,504 ($114,490 × 1.07).
Reversion
As mentioned previously, income-producing properties typically provide two types of
financial benefits—periodic income and the future value obtained from sale of the prop-
erty or reversion of the property interest at the end of the projection period. The length
of the projection period can usually be determined by reviewing the property’s lease
expiration dates or other significant, atypical events. The expectations of market partici-
pants are also relevant and must be considered. The length of the projection period and
the discount rate are interactive. Generally, the longer the projection period, the greater
the risk and the higher the discount rate. This future cash flow is called a reversion be-
cause it represents the anticipated return of a capital sum at the end of the investment.
There are several ways to estimate a resale price or property reversion. A capital-
ization rate can be applied to the appropriate income for the year following the end
of the forecast. When an overall capitalization rate is used to estimate a resale price, it
is called a terminal, going-out, exit, or residual capitalization rate (RN). This rate is differ-
ent from the going-in capitalization rate—which is the overall capitalization rate found
by dividing a property’s net operating income for the first year after purchase by the
purchase price of the property. The terminal, or residual, capitalization rate forecast is
generally, though not necessarily, higher than the going-in capitalization rate. The ter-
minal capitalization rate must reflect the reduction in the remaining economic life of
the property and the greater risk associated with estimating net operating income at

the end of the projection period. The balance of the mortgage could then be deducted
from the resale price or property reversion to calculate the owner’s net sale proceeds,
or equity reversion, if an equity yield analysis is being performed.
A single property may include one or more property interests that have their own
streams of periodic benefits and reversions. For example, a property may have an eq-
uity interest with equity cash flow as the periodic benefit and the equity reversion—
i.e., property reversion minus the mortgage balance at loan maturity or property
resale—as the reversionary benefit. The same property could have a mortgage with
debt service as the periodic benefit and the mortgage balance (called a balloon pay-
ment) as the reversionary interest.
The reversion is often a major portion of the total benefit to be received from
an investment in income-producing property. The effective rate of return on the
investment will be negative if the investor’s capital is not recaptured through some
combination of cash flow and reversion proceeds. For certain investments, all capital
recapture is accomplished through the reversion, generally indicating higher risk. For
other investment properties, part of the recapture is provided by the reversion and
part is provided by the investment’s income stream.
To judge how much of the return of an investment will be provided by the rever-
sion, an appraiser acknowledges that three general situations could result from the
original investment.
1. The property may increase in value over the projection period.
2. The property’s value may not change—i.e., the value of the property at the end of
the projection period may be equal to its value at the beginning of the period.
3. The property may decline in value over the period being analyzed.
Because these possible outcomes affect the potential yield of the investment and the
amount of income considered acceptable, yield capitalization requires an appraiser to
determine market expectations as to the change, if any, that will occur in the original
investment or the property value over the projection period. (For leveraged invest-
ments, equity build-up may also occur through periodic debt service payments that
include amortization.)
When a property is expected to be sold, an appraiser projects the reversion
amount and considers the net proceeds of resale. The term net proceeds of resale refers
to the net difference between a transaction price and the selling expenses, which may
include brokerage commissions, legal fees, closing costs, transfer taxes. The reversion
(forecasted resale price) should be carefully analyzed to determine if costs of repair,
capital improvements, environmental remediation, or other extraordinary costs (if
any) have been appropriately reflected. The reversion (forecasted resale price) may
have to be adjusted to reflect such costs incurred by either party.
An appraiser forecasts the likely value of the reversion in light of the expectations of
investors in the market for the type of property being appraised. The appraiser may ask
• Do investors expect a change in the value of this type of property in this particu-
lar locale?
• By how much will values change and in which direction?
• Do investors deduct closing cost or cost of sale for anticipated resale when they
are analyzing investment opportunities?

The appraiser analyzes and interprets the market and estimates the value of the
future reversion based on the direction and the amount or percentage of change that
investors expect. The use of personal computers and software to perform lease-by-
lease analysis allows appraisers to make more accurate forecasts of future cash flows,
which help them establish or estimate the reversion.
Discounting Models
The present value of any increasing, level, or decreasing income stream or of any
irregular income stream can be calculated with DCF analysis. Specific valuation mod-
els or formulas, categorized as either income models or property models, have been
developed for application to corresponding patterns of projected benefits.
Income models can be applied only to a stream of income. The present value of
an expected reversion or any other benefit not already included in the income stream
must be added to obtain the investment’s total present value. When a property model
is used, an income stream and a reversion are valued in one operation. Other present
value models employ discounted cash flow analysis, which is discussed in Chapter 27.
Income Models
Valuation models can be applied to the following patterns of income:
• Variable or irregular income
• Level income
• Straight-line (constant-amount) change per period income
• Exponential-curve (constant-ratio) change per period income (i.e., the K factor)
• Level-equivalent income
These models are not necessarily real estate- or property-specific, but they can be
used to solve a variety of financial asset valuation problems that involve real estate.
Variable or Irregular Income

As mentioned previously, a discounting process or formula can be used to solve any
present value problem. The present value of an uneven stream of income is the sum
of the discounted benefits treated as a series of separate payments or reversions. This
model simply totals all present values using the standard discounting formula. The
routine can be applied as a property valuation model or an income valuation model
because it can be adapted to include the final reversion as part of the final cash flow
expected at the end of the last, or nth, period.
Level Income
When a lease provides for a level stream of income or when income can be projected
at a stabilized level, one or more capitalization procedures may be appropriate
depending on the investor’s capital recovery expectations. Capitalization can be ac-
complished using what is known as capitalization in perpetuity. No income stream is
perpetual, but the classic conception of an income stream capitalized in perpetuity is
based on the assumption of an infinite level income stream. In other words, for the
purposes of the analysis, the income stream is considered to be unchanged for the
defined economic life of the improvements. The modern theory of an income stream
capitalized in perpetuity is based on the assumption of a finite level income stream

with its reversion equal to the present value. Although a finite income stream can-
not be considered perpetual, the label perpetuity is applied because an investment
with level income and no change in value behaves in the same manner as the classic
conception of a level income stream capitalized in perpetuity.
An income stream capitalized in perpetuity can be valued using direct capitaliza-
tion. However, the application of direct capitalization does not imply that the income
stream associated with the property is a perpetuity. Few investments are expected to
have no change in income and value over the projection period.4
Capitalization in perpetuity can be considered a property valuation model. If,
for example, a property is expected to generate level net operating income for a finite
period of time and then be resold for the original purchase price, the property could
be valued with capitalization in perpetuity simply by dividing the expected periodic
income by an appropriate discount rate. In this model, the discount rate and the
overall capitalization rate are of the same magnitude because the original investment
is presumed to be recovered at the termination of the investment.
Straight-Line (Constant-Amount) Change per Period in Income

When income is expected to increase or decrease by a fixed amount per period, the
periodic income over time can be graphically portrayed as a straight line. Thus, the
term straight-line is used to describe this type of income pattern.
To obtain the present value of an annuity that has a starting income of d at the
end of the first period and increases or decreases h dollars (or other unit of currency)
per period for n periods, the following equation is used:
h(n - an)
PV = (d + hn)an -
i
where an is the present value of $1 per period at a rate of i for n periods. In the formu-
las, h is positive for an increase and negative for a decrease.
The formula for valuing straight-line income patterns should not be confused with
direct capitalization with straight-line recapture. Although direct capitalization with
straight-line recapture may be seen as a model for valuing a particular income stream,
the procedure can also be applied to properties in which the expected change in value is
commensurate with the expected change in income. Therefore, direct capitalization with
straight-line recapture and related concepts are discussed with property models later in
this chapter. Again, the formula above for valuing straight-line income patterns applies
to income streams only. If this model is used, the reversion, if any, must be valued sepa-
rately. Special tables of present value factors based on the formula are available.5
Exponential-Curve (Constant-Ratio) Change per Period in Income

The constant-ratio model represents an income pattern that increases or decreases at
the same rate per period. Many real estate income streams are anticipated to increase
following a pattern close to the constant-ratio premise, although typically on a short-
4. In the past, some appraisers calculated the present worth of an income stream using the Inwood premise or the Hoskold premise, which are
discussed in Appendix C. Over time, the Hoskold premise has become less popular and rarely reflects the thinking of real estate investors. It is
now considered appropriate only for certain types of investments, e.g., in calculating the replacement allowance for leasing equipment or personal
property. A Hoskold capitalization rate can be easily constructed by adding the speculative rate to the sinking fund factor for the safe rate, e.g.,
the prevailing rate for insured savings accounts or government bonds.
5. See James J. Mason, ed. and comp., American Institute of Real Estate Appraisers Financial Tables, rev. ed. (Chicago: American Institute of Real
Estate Appraisers, 1982), Table No. 5, Ordinary Annuities Changing in Constant Amount; and Charles B. Akerson and David C. Lennhoff, ed.,
Capitalization Theory and Techniques Study Guide, 3rd ed. (Chicago: Appraisal Institute, 2009) for keystrokes.

term basis. Portrayed graphically, this type of income stream follows an exponential
curve rather than a straight line. This income pattern is sometimes referred to as
changing at a compound rate. Analysis of exponential-curve change is primarily accom-
plished with computers.
Level-Equivalent Income
All non-level income streams can be converted into a level-equivalent pattern. This
is particularly useful when the assignment requires that the conclusion be expressed
as a level income amount but the market is performing on a non-level basis. In most
markets, leases include a provision for increases over time, often in relation to an
index such as a consumer price index (CPI). Therefore, in such a case the appraiser
needs to first estimate the rent as it is found in the market, and then convert it into a
level-income equivalent.
Converting income into a level equivalent has two steps:
1. Calculate the present value of the irregular income stream at the appropriate
yield rate.
2. Calculate the level payment that has the same present value.
The second step can be accomplished by multiplying the present value by the install-
ment to amortize one factor at the yield rate. Another way to adjust the income to
a level equivalent is to calculate a factor that, when multiplied by the first year’s
income, results in the equivalent level income. When the income is forecast to change
at a compound rate, the K factor can be used to adjust it to a level equivalent:
Level Income = K factor × IO
Of course, the calculation for any pattern of income can easily be accomplished using
either a financial calculator or a computer.
Property Models
When both property value and income changes are expected to follow a regular or
predictable pattern, one of the yield capitalization models for property valuation may be
applicable. These common yield capitalization models employ a capitalization rate, R,
which is also used in direct capitalization. There is a difference, however, between direct
capitalization and yield capitalization. In direct capitalization, the capitalization rate R
is derived directly from market data, without explicitly addressing the expected rate of
return on capital or the means of recapture. In yield capitalization, R cannot be deter-
mined without considering the income pattern, the anticipated rate of return on capital,
and the timing of recapture. This does not mean that yield capitalization procedures are
not market-oriented. On the contrary, for some property types yield capitalization proce-
dures may represent the most realistic simulation of decision making in the marketplace.
Real estate investors are greatly influenced by expectations of change in property
values. When an investor looks forward to property appreciation as a component of
the eventual investment yield, that investor is anticipating that the total yield rate
will be higher than the initial year’s expected rate of income—i.e., the overall capital-
ization rate. The total yield rate is a complete measure of performance that includes
any property appreciation or depreciation upon resale and increase or decrease in
income. The general formula for this relationship is:
Y=R+A

where Y is the yield rate, R is the capitalization rate, and A is the adjustment rate that
reflects the change in income and value.
Thus, the capitalization rate for an appreciating property equals the total yield
rate minus an adjustment for expected growth:
R=Y-A
Similarly, the capitalization rate for a depreciating property can be seen as the yield
rate plus an adjustment for expected loss:
R = Y - (-A)
or
R=Y+A
Because A is often expressed as a function of the total relative change in property
income and value, the Greek letter delta (D) is used to denote change. To calculate A
it is usually necessary to multiply D by a conversion factor, such as an annual sinking
fund factor or an annual recapture rate, to convert the total relative change in value
into an appropriate periodic rate of change. The symbol for the annualizer is a. The
general formula for R may be expressed as
R=Y-D a
where R is the capitalization rate, Y is the yield rate, D is the total relative change in
income over the projection period, and a is the annualizer or conversion factor.
This general formula for the capitalization rate can be adapted and used with typi-
cal income/value patterns for the property as a whole or for any property components.
In the general formula, R, Y, and D apply to the total property and are expressed with-
out subscripts. However, if there is a possibility of confusing the total property with
any of its components, subscripts should be used for clarification—e.g., RO. Once the
appropriate capitalization rate has been determined, an indication of property value
can be obtained by applying the following universal valuation formula:
Income
Value =
Capitalization Rate
or
I
V=
R
Level Income
When both income and value are expected to remain unchanged, a property may be
valued by capitalization in perpetuity. (Again, for the purposes of the analysis, the
income stream is considered to be unchanged for the defined economic life of the im-
provements.) According to the general formula, R = Y - D a, the capitalization rate (R)
becomes the yield rate (Y) when there is no change in value because D equals zero.
When level income with a change in value is projected over a period of n years,
the general formula for R is adapted by substituting the sinking fund factor at rate Y
over n years in place of the conversion factor (a). For example, consider a commercial
property that will generate a stable net operating income of $25,000 per year for the
next eight years. Total property appreciation of 40% is expected during this eight-year
period because market rents are expected to exceed contract rents and the expiring
leases will provide an opportunity to release the property at higher rates. The apprais-

er concludes that the appropriate yield rate is 11%. To solve this problem, the formula
R = Y - D a is used with the sinking fund factor for 11% over eight years as a. Accord-
ing to the tables, the sinking fund factor is 0.084321, so R is calculated as follows:
R = 0.11 - (0.40 × 0.084321) = 0.076272
IO
Value (V) =
R
$25,000
V = = $327,776
0.076272
Property models used in solving for value can also be used to manipulate or
explain a given set of market data to determine other unknowns. For example, in the
problem above, only the net operating income and rate of change or appreciation
in property value are known. While DCF analysis may be used as proof of the solu-
tion, it is not feasible to apply DCF analysis to solve the problem. This is true because
only the rate of appreciation is known from the market, and the dollar amount of the
future reversion and the current present value are unknown and interdependent. This
illustrates the most significant benefits of the property models—i.e., the ability to make
value decisions based on broad trends as well as the ability to explain market behavior.
Straight-Line (Constant-Amount) Changes in Income and Value

When income and value are expected to increase or decrease by fixed amounts per peri-
od according to the standard, straight-line pattern, property value can be estimated using
direct capitalization with straight-line recapture. The general formula for the capitaliza-
tion rate (R) can be adapted for use with the standard, straight-line income/value pattern
by using the straight-line recapture rate as the conversion factor (a). The straight-line
recapture rate is simply the reciprocal of the projection period. For example, if income is
projected over a period of 25 years, the annual, straight-line recapture rate is 1/25, or 4%.
Depreciation of 100% would indicate that the projection period is equal to the remain-
ing economic life of the improvements. The concept of a limited remaining economic life
does not apply to appreciating properties, but 100% appreciation would indicate a pro-
jection period equal to the amount of time required for the property to double in value.
The straight-line capitalization procedure has historically been used to value
wasting assets, i.e., investments whose income is declining as their asset base wanes.
This classic procedure has limited applicability due to its underlying assumptions,
but it should be thoroughly understood to ensure its proper use. The classic straight-
line procedure is based on the expectation that capital will be recaptured in equal
dollar amounts during the investment’s economic life and that net income consists
of a declining amount that represents the return of capital plus a declining return on
the capital remaining in the investment. Total income, therefore, diminishes until the
asset is worthless and all capital has been recovered.
The presumption that value and income will decline steadily is frequently
inconsistent with market behavior. Nevertheless, the procedure has important uses.
Straight-line recapture is appropriate whenever the projection of income and value
in an investment corresponds with the assumptions implicit in the procedure. Classic
straight-line recapture is most easily understood when it is applied to an investment
in a wasting asset such as a perishable structure, a stand of timber, a landfill, or a
mineral deposit. The procedure is inappropriate for valuing an investment in land or
another asset that can sustain value indefinitely.

For example, consider an investment in a partial interest in real estate such as a
leasehold in which all improvements must be written off during the term of the lease.
If $50,000 is invested in a 10-year leasehold expected to earn 8% per year as a yield
on capital, what flow of income to the investor would be required to return the entire
amount of the investment on a straight-line basis during the 10-year period and, in
addition, yield 8% per year to the investor?
Yearly recapture would, of course, be one-tenth of $50,000, or $5,000. The investor
is entitled to a return on unrecaptured capital amounting to 8% of $50,000 in the first
year, 8% of $45,000 in the second year, 8% of $40,000 in the third year, and so forth
(see Table 26.1). The income flow starts at $9,000 the first year and drops by $400 each
year after that. The total income payable at the end of the tenth and final year would
be $5,400, of which $5,000 would be the last installment of the return of capital and
the other $400 would be the interest due on the capital remaining in the investment
during the tenth year. Thus, the investor achieves 100% capital recovery plus an 8%
return on the outstanding capital, assuming non-level income.
Note that the recapture rate amounts to 10% of the original investment and is sim-
ply the reciprocal of the economic life. Also, all income is presumed to be payable at
the end of each year, and the yields are always computed at the end of the year on the
amount of capital outstanding during the year. Based on the starting income, the capi-
talization rate in this example would be $9,000/$50,000, or 18%. The 18% capitalization
rate could also be calculated by adding the 10% recapture rate to the 8% yield rate.
Table 26.1 Periodic Return of and Return on Capital

End of Year Invested Capital Return of Capital Return on Capital Total Income
0 $50,000 — — —
1 45,000 $5,000 $4,000 $9,000
2 40,000 5,000 3,600 8,600
3 35,000 5,000 3,200 8,200
4 30,000 5,000 2,800 7,800
5 25,000 5,000 2,400 7,400
6 20,000 5,000 2,000 7,000
7 15,000 5,000 1,600 6,600
8 10,000 5,000 1,200 6,200
9 5,000 5,000 800 5,800
10 0 5,000 400 5,400
The straight-line capitalization procedure reflects some useful mathematical

relationships:
First Period Return on Investment = Original Value × Yield Rate
Periodic Change in Value = Original Value × Periodic Rate of Change
Periodic Change in Income = Periodic Change in Value × Yield Rate
When the decline in income and value reflects these relationships, the periodic rate of
change is the recapture rate and the reciprocal of the recapture rate is the economic life.
The traditional concept of straight-line recapture can be expanded to remove
some of its theoretical constraints and facilitate a broader range of practical applica-

tions. The expectation of a predictable decline in income can be expanded to include
any predictable change, which allows an appraiser to consider growing assets as well
as wasting assets. A predictable rate of change within the foreseeable future can also
eliminate the need to consider the full economic life of a property. Although there are
significant theoretical differences, the expanded straight-line concept corresponds
mathematically to classic straight-line recapture.
Under both the expanded and classic straight-line concepts, changes in value and
income are presumed to occur on a straight-line basis. The basic requirements for a
satisfactory return on, and complete recovery of, invested capital are also preserved.
However, the expanded concept does not require that capital be recaptured in annual
installments throughout the economic life of a property. Rather, the property could
be resold for a predictable amount at some point during its economic life, thereby
providing for partial or complete return of the invested capital at the time of resale.
The straight-line capitalization rate is simply a combination of the yield rate and
the straight-line rate of change, which is expressed in the general formula R = Y - D a,
where D is the relative change in value in n periods and a is 1/n. For example, con-
sider a leased fee interest that will produce income to the leased fee (ILF) of $19,000
the first year. This income stream is expected to decline thereafter in the standard
straight-line pattern and value is expected to fall 25% in 10 years. The anticipated
income pattern must match up with the lease contract. To appraise the leased fee to
yield 12%, the formula RLF = YLF - DLF a is used, where the subscript LF denotes the
leased fee.
RLF = 0.12 - (-0.25 × 0.1) = 0.145
I $19,000
Value = LF = = $131,034
R 0.145
The classic and expanded straight-line concepts are easy to understand and the
math is simple. However, straight-line concepts have theoretical and practical limita-
tions. The straight-line premise is seldom a realistic reflection of investor expectations
of changing income and value.
Exponential-Curve (Constant-Ratio) Changes in Income and Value

When both income and value are expected to change at a constant ratio, the capital-
ization rate can be determined without tables using the general formula
R = Y - ∆ a
where Δ a is the relative change in value and income for one period. Thus, Δ a can be
replaced with the periodic compound rate of change (CR). The formula then becomes
R = Y - CR
where Y is the yield rate per period and CR is the rate of change per period. An ex-
pected loss is treated as a negative rate of change, and the formula becomes
R = Y - (-CR)
or
R = Y + CR
If both income and value are expected to change at the same compound rate, the
capitalization rate is expected to remain constant. Therefore, this pattern of growth or
decline is sometimes referred to as the frozen cap rate pattern. For example, suppose an

income-producing property is expected to produce net operating income of $50,000
for the first year. Thereafter both net operating income and value are expected to
grow at a constant ratio of 2% per year. In other words, 2% is the expected ratio of the
increase in income for any year to the income for the previous year. The ratio of the
increase in value for any year to the value for the previous year is also 2%. To ap-
praise the property to yield 11%, the formula is
RO = YO - CR = 0.11 - 0.02 = 0.09
$50,000
Value = = $555,556

0.09
The elements in the above equation can be transposed so that
YO = RO + CR
The overall yield rate, therefore, is equal to the overall capitalization rate plus the pe-
riodic adjustment, provided the rate of change is anticipated to continue at the same
rate into the foreseeable future. Property models based on an exponential pattern of
change in income and value often reflect the thinking of investors in the market.
Variable or Irregular Income and Value Changes

When income and value are not expected to follow a regular pattern of change, the
present value of a property can be obtained by applying the standard discounting
formula separately to each projected benefit, including the final reversion. This is
often done using discounted cash flow analysis rather than an income or property
model. Examples of applications of discounted cash flow analysis are provided in
Chapter 28.
Level-Equivalent Income
As noted previously, any pattern of income can be converted into a level-equivalent
income. Therefore, the level income property model, R = Y - Δ Sn, can be used to
solve for the value of any pattern of income once that income has been converted into
its level equivalent. Suppose, for example, an appraiser is valuing a property with
net operating income of $200,000, growing at 4% per year. If the value is expected
to increase 15% over a five-year projection period (ΔO = 15%) and the appropriate
yield rate is 12%, the value can be calculated by first calculating the level-equivalent
income and then dividing that income by an overall capitalization rate developed us-
ing the level income property model.
To calculate the level-equivalent income, first calculate the present value of the
cash flows at the 12% yield rate:
Year Net Income
1 $200,000
2 $208,000
3 $216,320
4 $224,973
5 $233,972
The net present value of the income stream at 12% is $774,096. This is easily converted to
a level equivalent by multiplying it by the installment to amortize one factor, 0.277410.
Level-Equivalent Income = $774,096 × 0.277410 = $214,742

The level-equivalent income can be calculated using a financial calculator with the
following keystrokes:
200,000 g K
208,000 g K
216,320 g K
224,973 g K
233,972 g K
12 ¼
fl
Solve for P.
Alternatively, the following keystrokes can be used:
1.04 \\\
200,000 g K
µgK
µgK
µgK
µgK
12 ¼
fl
Solve for P.
Next, the overall capitalization rate is developed using the level income property
model.
RO = YO - ∆a = 0.12 - 0.15(0.157410*) = 0.096389
* Sinking fund factor, calculated using a financial calculator with the following keystrokes: 5 w, 12 ¼, 1 Þ M, solve for P
The value can then be obtained with the formula V = I as follows:

R
$214,742
V= = $2,227,879
0.096389
There are many other ways to solve this problem. The level income capitalization
rate, for example, could have been divided by the K factor for income growing at 4%
per year for 5 years and a 12% yield rate. That factor, 1.073709, is easily found using a
financial calculator, a computer, or published tables. The following keystrokes can be
used on a financial calculator to calculate the K factor:
1.04 \ \ \
1 g K
µgK
µgK
µgK
µgK
12 ¼
fl
Solve for P.
The capitalization rate developed using the K factor, 0.089772, would then be
divided into the first year’s net operating income of $200,000 to yield the same value

conclusion. In fact, because the calculation is so easily obtained—for any income pat-
tern—from a financial calculator or computer, little emphasis is given to the use of pre-
calculated factors. The factors are useful, however, in presenting the analysis to a client.

Discounted Cash Flow Analysis 27
and Investment Analysis
Discounted cash flow (DCF) analysis is an appropriate tool for valuing any pattern
of regular or irregular income. In many markets and for many property types, DCF
analysis is the technique that investors prefer. Properly applied, DCF analysis identi-
fies the market conditions investors are anticipating as of the date of value.1
Some critics argue that DCF analysis is too speculative, but the technique is not
an unsupported prediction by an appraiser. Appraisers who use DCF analysis are
simply identifying what investors expect on the date of appraisal and build into their
pricing models. Whether the expectations of investors are realized or not, the ap-
praisal will be prepared properly if the appraiser has correctly identified the inves-
tor’s expectations on the date of appraisal.
Applicability of DCF Analysis

Generally, DCF analysis is used to solve for present value given the rate of return or
to solve for the rate of return given the purchase price. Discounted cash flow analy-
sis can be used both to estimate present value and to extract a yield or discount rate
from a comparable sale.
In typical appraisal work, an appraiser begins by developing detailed spreadsheets.
These spreadsheets show itemized incomes, expenses, and cash flows year by year,
or sometimes month by month, over the presumed period of ownership or another
projection period that the market suggests. The cash flows, including the net resale
price, are then discounted at an appropriate rate (or rates) to derive an indication of
present value. In this way, an appraiser can account for all cash flows in and out of the
real property interest being appraised and estimate the timing of these cash flows so
that the time value of money is properly recognized in the analysis. Alternatively, if the
yield is sought, these cash flows are calculated given the purchase price being realized.
Data related to cash flows and compounding or discounting conventions must
be derived from consistent sources. For example, if a market-derived discount rate is
1. See Advisory Opinion 33 of the Uniform Standards of Professional Appraisal Practice.

extracted based on annual cash flows and end-of-period discounting, an appraiser’s
analysis of cash flows should be based on these same expectations. If different expec-
tations are applied (e.g., semiannual cash flows with beginning of period discount-
ing), the discount rate used must be adjusted to account for the difference from the
application of market-extracted terms (e.g., end-of-period discounting in arrears).
When the objective of an appraisal is to develop an opinion of market value, the
frequency of discounting cash flows must reflect the actions of prospective inves-
tors. For example, the discount rates normally quoted by investors presume annual
discounting in arrears. If an appraiser were to divide annual discount rates by 12 and
analyze discounted cash flows on a monthly basis arguing that this is how the cash
flows occur, those calculations would result in a higher value indication than the
DCF analysis of annual cash flows. This result would not reflect the market value of
the property because the discount rate was applied incorrectly.
Critics of DCF analysis point out that projections not warranted by market evi-
dence can result in unsupported market value indications and that the results of the
analysis can change significantly due to even small changes in the projections. Other
critics object to the uncertainty of forecasting financial results 5 or 10 years into the
future and cite this as a reason for not using or relying on the DCF technique. How-
ever, these arguments ignore the reality of the real estate marketplace. Investors do
make forecasts and rely on DCF analysis, particularly in regard to large, investment-
grade, multitenant properties such as shopping centers and office buildings and
properties with nonstabilized incomes such as new buildings that require lease up.
When yield capitalization was first expanded in applications of the valuation
process by L. W. Ellwood in the 1960s, there was initial confusion over mathematical
processes and relationships that are now commonly understood. At first, many ap-
praisers mistakenly believed that yield capitalization could only apply to long-term,
dependable income streams. Ellwood held two positions that were considered novel
at the time but were factual expressions of already accepted appraisal principles.
• First, he recognized that any form of capitalization was unreliable and potentially
misleading unless the net income to be capitalized was accurately developed
with market support.
• Second, he established that the yield rate for capitalization should be the market
yield rate that would relate that net income (over time) to market value.
Ellwood believed that variations could be used to test and understand market
behavior. For example, if the incomes including the reversion were expressed in an
income statement, even a statement covering only 5 years, the effects of lesser uncer-
tainty in the early property incomes and greater uncertainty of the reversion amount
would be mitigated in present value discounting processes. In capitalization, the con-
tribution to present value decreases as the time elapsed from the date of value increas-
es, so greater weight is afforded to those “knowns” that are closest to the date of val-
ue. Although the discounting processes involved once required significant amounts of
time (for formula calculations and to search for rates in printed tables), appraisers can
now perform the calculations relatively quickly with financial calculators or computer
software once the DCF model has been set up and all inputs included.
In keeping with the principle of anticipation, market-supported forecasting is the
essence of valuation. Hence, it must be approached in the same way that all market
data extractions are accomplished—i.e., with diligent research and careful verification.

Discounted cash flow analysis can only provide accurate results if the forecasts devel-
oped are based on accurate, reliable information. Unless real estate income is defined
by contract at a level amount or has a defined pattern over the course of the lease term,
most income streams will vary from year to year, particularly with changes in business
cycles or local property markets. It is most common for appraisers to develop a “stabi-
lized” income stream, which may be level or exhibit some consistent rate of change, to
represent a property’s income for yield capitalization purposes. This practice follows
procedures commonly applied by buyers and sellers, and the application of the tech-
nique should mirror the reasoning and behavior of those market participants.
Investment Analysis
In addition to developing an opinion of value or extracting a yield rate from compa-
rable sales, discounted cash flow analysis techniques are often used to test the perfor-
mance of real estate investments at a desired rate of return. Measures of investment
performance include
• Net present value
• Internal rate of return
• Payback period
• Profitability index (or benefit/cost ratio)
• Time-weighted rate
Used alone, these measures sometimes produce limited conclusions, but as a col-
lection of tools they have proven their effectiveness. They reflect a common market
understanding and are useful in typical real estate applications.
Forecasting
In making forecasts an appraiser employs the same procedure applied by investors who use DCF analysis
in their decision making. The procedural steps typically include forecasting income, vacancy, operating and
capital expenses, and equity income (if appropriate) over ownership periods of, for example, 5 to 15 years. In
some markets and in some situations, 10 years is cited as an average or standard projection period or a typi-
cal ownership period. In others, the forecast period may be shorter or longer. When appropriate, debt service
and after-tax cash flow may also be forecast. The residual income from the sale of the property at the end of
the forecast period is also estimated.
Typical forecast categories to be addressed in DCF analysis include
• Current market rental rates, lease expiration dates, and expected rental rate changes
• Lease concessions and their effect on market rent
• Existing base rents and contractual base rent adjustments
• Lease extensions and renewal options
• Existing and anticipated expense recovery (escalation) provisions
• Tenant turnover
• Vacancy loss and collection allowance
• Operating expenses and changes over the projection period
• Net operating income
• Capital items including leasing commissions and tenant improvement allowances
• Reversion and any selling or transaction costs
• A discount or yield rate (or rates)
Discounted Cash Flow Analysis and Investment Analysis 495

Net Present Value and the Internal Rate of Return
Net present value (NPV) and the internal rate of return (IRR) are two discounted
cash flow models widely used to measure investment performance and develop
decision-making criteria. Net present value (dollar reward) is the difference between
the present value at a desired yield (discount) rate of all positive cash flows and the
present value of all negative cash flows, or capital outlays. When the present value
of the positive cash flows is greater than the present value of the negative cash flows
or capital outlays, the investment exceeds the return requirements of the investor. If
the reverse relationship exists (i.e., negative cash flows are greater than positive cash
flows), the investment is not considered feasible at the desired yield, or at least not at
the discount rate used to calculate present value. However, other investors may find
the investment feasible.
A net present value of zero indicates that the present value of all positive cash
flows equals the present value of all negative cash flows or capital outlays at the
discount rate. The rate of discount that makes the net present value of an invest-
ment equal zero is the internal rate of return. In other words, the IRR is the rate that
discounts all returns from an investment, including returns from its termination, to a
present value that is equal to the original investment.
A number of decision rules for applying the NPV can be established. For ex-
ample, suppose that a property with an anticipated present value of $1.1 million for
all investment returns over a 10-year projection period can be purchased for $1.0
million. If one investor’s NPV goal is $0, this investment exceeds that criterion. It also
meets a second investor’s goal for an NPV of $100,000, but it would not qualify if the
goal were $150,000.
Net present value considers the time value of money, and different discount
rates can be applied to different investments to account for general risk differences.
However, this method cannot handle different required capital outlays. For example,
it cannot differentiate between an NPV of $100,000 on a $1,000,000 capital outlay and
the same NPV on a $500,000 capital outlay. Therefore, this technique is best used in
conjunction with other measures.
A common example of the use of an NPV analysis is called a hurdle rate analy-
sis. Some investors use a stated yield rate, which is the minimum acceptable rate of
return for that investor, to determine the extent to which a potential investment can
exceed that minimum. If there is a surplus of NPV above zero to justify further at-
tention, the investor can then spend the time and resources to pursue a more precise
estimate of potential investment yield if the investment otherwise appears to be
worth the exercise.
As a simple example of calculating the internal rate of return, consider the in-
come data in Table 27.1. The internal rate of return of 11.37% can be calculated using
the following HP-12C financial calculator keystrokes:
1,600,000 Þ g J
100,000 g K
5,000 Þ g K
110,000 g K
115,000 g K
2,330,000 g K
f L.

Plotting the net present values of the income streams at a variety of discount rate, as
shown in Figure 27.1, illustrates where NPV crosses the x-axis (i.e., where NPV = 0) at
the IRR.
Table 27.1 Net Cash Flow

Y ear Income Reversion Net Cash Flow
0 -$1,600,000 -$1,600,000
1 $100,000 $100,000
2 -$5,000 -$5,000
3 $110,000 $110,000
4 $115,000 $115,000
5 $230,000 $2,100,000 $2,330,000
Figure 27.1 Graphic Analysis of IRR

$1,200,000
$1,000,000
$800,000
$600,000
Net Present Value
$400,000
$200,000
0
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Discount Rate
($200,000)
($400,000)
By understanding the limitations and pitfalls appraisers may encounter using

the IRR, practitioners can avoid wasted effort and false conclusions. The search for a
single IRR within a plausible range is not always successful. Unusual combinations
of cash flows may produce strange results, and more than one IRR—or, in rare cases,
no IRR—may be indicated.
More Than One Internal Rate of Return

More than one internal rate of return is only possible with the presence of nega-
tive cash flows. Consider a real estate investment in which the investor puts down
$23,000, borrows $100,000, and pays 10% interest only, with the principal to be repaid
in a lump sum at the end of 10 years. The investor’s net cash flows can then be tabu-
lated as shown in Table 27.2.

Table 27.2 Net Cash Flow
Y ear Cash Flow before Loan/Interest Loan Interest Net Cash Flow
0 -$123,000 * $100,000 $0 -$23,000
1 $20,000 $0 -$10,000 $10,000
2 $20,000 $0 -$10,000 $10,000
3 $20,000 $0 -$10,000 $10,000
4 $20,000 $0 -$10,000 $10,000
5 $10,000 $0 -$10,000 $0
6 $10,000 $0 -$10,000 $0
7 $10,000 $0 -$10,000 $0
8 $10,000 $0 -$10,000 $0
9 $10,000 $0 -$10,000 $0
10 $90,000 † -$100,000 -$10,000 -$20,000
* Initial cash outlay
† Income and proceeds from sale
The internal rate of return for the net cash flows after financing can be obtained
through graphic analysis. Net present values are calculated for even discount rates
between 0% and 24% and plotted on a graph. Table 27.3 and Figure 27.2 indicate not
one, but two, internal rates of return. Using a computer, the two IRRs are calculated
as 4.50839% and 18.3931%.
Multiple rates like these are interesting from a theoretical viewpoint, but it is
difficult to accept more than one internal rate of return as a useful measure of perfor-
mance. In real estate investment analysis, the presence of multiple internal rates of
return usually suggests that some other measure of performance (usually net present
value analysis) would be more appropriate or that the cash flows or the time frame
should be adjusted to permit a more meaningful analysis.
Negative Net Present Value at Zero Rate of Return

The cumulative value of the net cash flows in Table 27.2 is negative. Negative net
cash flows total $43,000, while positive net cash flows total $40,000. Therefore, the net
present value—i.e., the difference between the present value of expected benefits, or
positive cash flows, and the present value of capital outlays, or negative cash flows—
with no discounting or at a zero discount rate is -$3,000, as shown in Figure 27.2. This
should be a warning sign to an analyst.
Under these conditions, the internal rate of return cannot be positive unless the
mixture of positive and negative cash flows over time is such that the net present
value increases with increases in the discount rate until the net present value reaches
zero. This type of reverse discounting is mathematically valid, but it is contrary to the
practical notion of reducing net present value by increasing the discount rate. It is not
surprising that, in cases like this, the internal rate of return is difficult to comprehend
and of questionable use.
For a given discount rate (Y), the following statements apply:
• If the present value (PV) of future benefits is greater than the capital outlay (CO),
the net present value (NPV) is greater than zero and the internal rate of return
(IRR) is greater than the discount rate.

Table 27.3 Table of Net Present Values
Discount Rate Net Present Value
0 -$3,000
2 -$1,330
4 -$212
6 $483
8 $857
10 $988
12 $934
14 $742
16 $448
18 $79
20 -$343
22 -$802
24 -$1,284
Figure 27.2 Graphic Solution to Example

$1,500
$1,000
$500
$0 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26%

Discount Rate
Net Present Value
-$500
-$1,000
-$1,500
-$2,000
-$2,500
-$3,000
-$3,500
• If the present value of future benefits is less than the capital outlay, the net present
value is less than zero and the internal rate of return is less than the discount rate.
• If the present value of future benefits is equal to the capital outlay, the net present
value equals zero and the internal rate of return is equal to the discount rate.
The formulas are:
If PV of future benefits > CO → NPV > 0 and IRR > Y
If PV of future benefits < CO → NPV < 0 and IRR < Y
If PV of future benefits = CO → NPV = 0 and IRR = Y

Negative Internal Rate of Return
If the net present value of an investment at a 0% rate of return is negative, a nega-
tive internal rate of return may be indicated. The IRR is generally understood to be
a positive rate of return, but a negative IRR may be interpreted as a rate of loss. Any
prospective rate of loss will normally discourage capital investment.
The concept of a negative internal rate of return has theoretical, as well as practical,
limitations. A glance at the IRR equation reveals that a negative IRR of 100% or more
has no meaning because it involves division by zero or powers of a negative number.
Little or No Equity
Because the internal rate of return is a measure of the return on invested capital, it
cannot be used to measure the performance of opportunities that require no invest-
ment of capital. Some investments can be “financed out”—i.e., financed with loans
that cover 100% or more of the capital required. If the projected net cash flows are all
positive, there is no IRR. Obviously, no discount rate can make a series of exclusively
positive benefits equal zero.
The same rationale can be applied to investments calling for very low equity or a
very small down payment in relation to expected returns. For example, a profit of $1
on an investment of $1 amounts to a 100% rate of return. A return of $100 on an invest-
ment of $1 indicates a 10,000% rate of return. When the investment is very small, slight
changes in income can cause astronomical changes in the rates of return and loss. The
internal rate of return is an impractical yardstick for these sorts of investments.
However, the IRR can be a valuable indicator in analyzing investments that are
100% financed at the start and are expected to operate at a loss for a period of time. In
these arrangements, the early negative cash flows may represent a significant invest-
ment of equity capital, and the prospective IRR may be the best measure of perfor-
mance. It may also be useful to compare the prospective IRR before financing with an
interest rate that reflects the cost of capital. The difference can be used as a measure
of prospective leverage.
Reinvestment Concepts
The internal rate of return on the capital within an investment can be applied to a
single property or to an entire investment portfolio. No assumption is made as to how
the investor actually employs funds that are received during the investment’s owner-
ship. The income from a real estate investment may be reinvested in another project at
another rate of return, stored in a vault, or spent, but the IRR is not affected. Regard-
less of whether or not an investor in fact reinvests capital withdrawn from the invest-
ment at any given rate, a defining characteristic of the internal rate of return is that it
is mathematically consistent with reinvestment at the same rate of interest as the IRR.
This establishes a framework for distinguishing between the internal rate of return
and other measures of investment return that make explicit reinvestment assumptions.
Incorporating a reinvestment concept in investment analysis is useful when
viewing returns within the context of overall portfolio performance. It is a funda-
mental concept of finance that to calculate a rate of return on an investment and to
compare two or more alternative investments, all of the funds in an investment must
be considered over the entire period of analysis. Income-producing real estate typi-
cally generates both a return on and a return of the invested capital over the life of
the investment. The rate of return can differ with various reinvestment assumptions.

As described earlier, there are potential problems with the concept of an internal rate
of return, but its use does not force any particular reinvestment assumptions, even
though it is consistent with reinvestment at the same rate as the IRR.
As discussed above, one problem associated with the internal rate of return is
that certain situations (such as negative cash flow) can produce mathematical results
that support more than one rate. A different rate of return concept with a specific re-
investment premise is sometimes used to avoid multiple IRRs. Although the assump-
tion of a specific reinvestment rate other than the IRR does not result in an internal
rate of return, reinvestment assumptions are applied in a number of rate of return
concepts that make up a family of IRR-related measures.
The IRR with reinvestment is based on the expectation that all income from a proj-
ect can be immediately reinvested at a specified rate and left to grow at that rate until
the end of the investment projection period. The combined results of the investment’s
earnings and reinvestment are then reflected in one overall rate of return. The IRR
with reinvestment traces the expected total performance of the original capital sum at
work in more than one investment, rather than ignoring what occurs with portions of
the capital investment during the ownership period. This measure can also be used
to prevent multiple solutions to the internal rate of return equation. The IRR with
reinvestment is often called the adjusted or modified IRR (AIRR or MIRR).2
As an example, consider the series of equity cash flows with a reinvestment rate for
positive cash flows of 6% shown in Table 27.4. The sum of the future values of the posi-
tive cash flows is $473,208. Comparing the future value with the present value of the ini-
tial investment using a financial calculator will give an equity MIRR of 13.61% with the
reinvestment rate of 6%, which is lower than the IRR of 14.8%. Using the IRR of 14.8%
as the reinvestment rate in the calculations of MIRR would give an MIRR of 14.8%.
The IRR with a specified borrowing rate is another variation of the internal rate
of return that can be used to prevent multiple rates. It is sometimes called the IRR
for investment or financial management rate of return (FMRR). The IRR for investment
specifies an interest rate for the borrowed funds needed during the period when the
investment is producing negative cash flows. As with other rates derived from the
internal rate of return, the FMRR recognizes that there are different risks and poten-
tial earnings that apply to the funds withdrawn from the original investment. The
Table 27.4 Equity Cash Flow with Reinvestment

Year Equity Cash Flow Future Value of Positive Cash Flow*
0 -$250,000
1 $20,000 $25,250
2 $35,000 $41,686
3 $20,000 $22,472
4 $30,000 $31,800
5 $50,000 $50,000
Reversion $300,000 $300,000
* The future value of the positive cash flows is calculated with a HP-12C financial calculator using the following keystrokes for Year 1: 4 w, 6 ¼,
20,000 $, 0 P, solve for M. Note that the term of reinvestment for the Year 1 cash flow is four years (from the end of the first year to
the end of the fifth year).
2. The algebraic formula for the MIRR appears in Appendix C.

concept of financial management indicates that lower rates will be paid on borrowed
funds and that risk management will permit the investor to eventually earn a higher
rate of return on the real estate investment. Again, to derive the FMRR, the entire
amount of invested capital is analyzed over the life of the real estate investment, as is
the case with other rates that assume reinvestment (AIRR and MIRR).
As an example of the calculation of an FMRR, consider the series of cash flows
in Table 27.5, which have an IRR of 21.47%. In this scenario, the cash flow of Year 2 is
reduced by $23,810, which is invested at a safe rate of 5% to cover the $25,000 outlay
in Year 3. Furthermore, the $100,00 outlay at the end of Year 1 is discounted at the
safe rate to be accounted for as part of the initial investment. Finally, the positive cash
flows are compounded at an appropriate rate—in this case, 7.5% was used—and the
financial management rate of return can then be calculated as 17%.
Table 27.5 Positive Cash Flows

Year Cash Flow Remove Outlays Discount Outlays Present Value of
Using Prior Inflows* at Safe Rate Positive Cash Flows†
0 -$50,000 -$50,000 -$145,238 -$145,238
1 -$100,000 -$100,000 $0
2 $50,000 $26,190 $26,190
3 -$25,000 $0 $0
4 $80,000 $80,000 $80,000
5 $200,000 $200,000 $200,000 $318,536
* In this example, inflows are invested at a safe rate of 5%.
† In this example, an interest rate of 7.5% is used to compound the positive cash flows.
Applicability
The internal rate of return can be as important to the real estate investor as the interest
rate is to the mortgage lender. In fact, the two measures are equivalent. The interest
rate on a mortgage is the same as the mortgagee’s yield, or the internal rate of return,
unless points or other payments such as prepayment penalties are involved. The inter-
nal rate of return is not a meaningful measure of all investments and, even when it is
meaningful, it is not the only possible criterion. It is, however, a fundamental and pure
measure of a particular investment’s financial performance. In general, the internal rate
of return is a valuable analytical tool if the decision maker understands its attributes
and limitations and has access to complementary or alternative analytical techniques.
Other Measures of Performance

Popular alternative measures of financial performance or profitability include
• Payback period
• Profitability index or benefit/cost ratio
• Time-weighted rate
These yardsticks do not measure performance or profit on the same scale or under
the same assumptions as the internal rate of return. Their usefulness depends on the
situation and the user’s preferences. Neither the internal rate of return nor any alter-
native measure is superior in all situations.

Payback Period
As a measure of investment return, the payback period is seldom used alone. It is
commonly employed in conjunction with other measures such as the internal rate
of return. The payback period (PB) is defined as the length of time required for the
stream of net cash flows produced by an investment to equal the original cash outlay.
The breakeven point is reached when the investment’s cumulative income is equal to
its cumulative cost or loss. The payback period can be calculated from either before-
tax or after-tax cash flows, so the type of cash flow selected should be identified. The
equation for payback period may be expressed as follows:
Capital Outlay
PB =
Annual Net Cash Flows
Because real estate appraisers typically account for income as if received annually at
the end of the period, full payback is not considered to occur until the end of a year.
Therefore, the payback period indicated by the prior equation will be rounded up to
a whole number, i.e., to the end of the next year.
This measure of performance is used by investors who simply want to know how
long it will take them to recapture the funds they have invested. In theory, an invest-
ment with a payback period of three years would be preferable to one with a payback
period of five years, all else being equal. Similarly, an investment that will return the
investor’s capital in six years would be unacceptable to an investor who seeks invest-
ment payback within four years.
For an equity investment that is expected to produce equal cash flows, the pay-
back period is simply the reciprocal of the equity capitalization rate:
1
PB =
RE
where the equity capitalization rate (RE) is rounded up to the next whole number.
For example, if RE = 15%, then PB = 1/0.15 = 6.67. If annual equity cash flows are not
expected to be equal over the payback period, the equity cash flows for each year
must be added until the sum equals or exceeds the equity capital outlay. This point
indicates the year in which payback occurs.
Although the payback period is simple and easily understood, it has several
drawbacks. First, it measures the amount of time over which invested money will
be returned to the investor, but it does not consider the time value of the money
invested. A five-year investment payback for a $100,000 investment that pays $10,000
in Year 1 and $90,000 in Year 5 is not distinguished from the payback for a $100,000
investment that pays $90,000 in Year 1 and $10,000 in Year 5. The time value of money
allows the first investment to use an additional $80,000 (i.e., the difference between
the $90,000 paid in the second investment and the $10,000 paid in the first invest-
ment) from the second year through the fifth.3
Another shortcoming of the payback period is that it does not consider the ef-
fect of any gain or loss of invested capital beyond the breakeven point and does not
specifically account for investment risks. An investment with a three-year payback
may be far riskier than another investment with a five-year payback, but the shorter
3. A more sophisticated, but less popular, measure is the discounted payback period, which recognizes the time value of money at a stipulated rate
of return. In this context the payback period is the amount of time required for the discounted benefits to equal the discounted costs.

period generally appears preferable. Thus, this measure of performance should only
be used to compare investments with similar investment characteristics or in con-
junction with other performance measures in carefully weighted applications.
Despite its shortcomings, the payback period is used by investors in situations
like feasibility analyses for the renovation of apartment buildings. Investors make
decisions about renovation (e.g., how much new investment to make, if any) by
considering how soon they can recoup their investment. For example, if an investor’s
payback objective is for a two-year holding period and the investor will recoup the
dollar amount in two years in the form of higher rent, then the renovation will be
performed. Even investors in large assets are able to use this simple, but pragmatic,
approach with no discounting.
Profitability Index
Although measuring the investment proceeds per dollar invested is too imprecise for
general use, a refinement of this technique is commonly applied in investment analy-
sis. The profitability index (PI), which is also called the benefit/cost ratio, is defined as
the present value of the anticipated investment returns (benefit) divided by the pres-
ent value of the total initial and annual, if any, capital outlay (cost). The formula is
Present Value of Anticipated Investment Returns
PI =
Present Value of Total Capital Outlay
This measure employs a desired minimum rate of return or a satisfactory yield
rate. The present value of the anticipated investment returns and the capital outlay
are calculated using the desired rate as the discount rate. If, for example, the capital
outlay is $12,300 and the present value of the benefits, based on a satisfactory yield
rate of 10%, is $13,100, the profitability index is $13,100/$12,300 = 1.065.
A profitability index greater than 1.0 indicates that the investment is profitable
and acceptable in light of the chosen discount rate. A profitability index of less than
1.0 indicates that the investment cannot generate the desired rate of return and is
not acceptable. A profitability index of exactly 1.0 indicates that the opportunity is
just satisfactory in terms of the desired rate of return and, coincidentally, the chosen
discount rate is equal to the anticipated internal rate of return. The discount rate used
to compute the profitability index may represent a minimum desired rate, the cost of
capital, or a rate that is considered acceptable in light of the risks involved.
A profitability index is particularly useful in comparing investments that have
different capital outlay requirements, different time frames for receiving income or
other investment returns, and different risk characteristics. A profitability index is
commonly used in conjunction with other measures, particularly with net present
value. When combined, these measures provide special insights into the investments
under consideration.
Time-Weighted Rate
A time-weighted rate is technically an average of all actual rates at different points
over a period of time. It is similar to the rate of growth for capital invested in a mutu-
al fund in which all dividend income is automatically reinvested. The time-weighted
rate, which is also known as the unit-method rate or the share-accounting rate, is used
primarily to measure the performance of a portfolio manager, not the performance of
the portfolio itself.

Applications of the Income 28
Capitalization Approach
Chapters 23 through 27 described the basic theory and procedures of the income cap-
italization approach and introduced a number of specific techniques. The examples
presented in this chapter illustrate the most common techniques used in applying the
income capitalization approach.
Applications of Income and Expense Analysis

As discussed in Chapter 24, a thorough analysis of the income and expenses of the
subject property and comparable properties is the starting point for application of
the capitalization procedures. The forecast of income and expenses can be for a single
year, if direct capitalization is going to be used, or for multiple years, if a yield capi-
talization technique is more appropriate.
Sample One-Year Income and Expense Forecast

The property being appraised, Southside Apartments, is a three-year-old, 55-unit
apartment project. Pertinent information for forecasting income and expenses follows:
• The gross potential rental income at 100% occupancy (based on actual rents) is
$1,101,600.
• Open parking is included with the rent.
• Additional income from coin-operated equipment averages about $4,140 per year
at full occupancy so the total, annual potential gross income at l00% occupancy is
$1,105,740.
• Annual vacancy and collection loss is estimated at 4%.
• Local management services are available for 5% of effective gross income.
• Last year’s real estate tax bill was $53,625, but taxes are expected to be $56,100 by
the end of this year. A sale of the property does not trigger a reassessment. Taxes
are expected to increase 3% per year.
• The owner carries $1 million in fire and extended coverage insurance and pays
an annual premium of $4,700. The appraiser believes that this coverage should
be increased to $1.2 million with a premium of $5,640 (1.2 × $4,700 = $5,640). The
additional expense for other insurance coverage is $2,310 per year and is a typical
requirement.
• The part-time building superintendent receives an annual salary of $50,400, in-
cluding fringe benefits.
• The cost to cover site maintenance and snow removal averages $17,700 per year.
• Building tenants pay their own utilities, including gas and electricity for indi-
vidual apartment heating and air-conditioning units. Based on the expenses of
the comparables and anticipated rate changes, the electricity for public space is
expected to cost $6,600 in the coming year. Expenses for other utilities, including
water, consistently run about $3,000 each year.
• Historically, repair and maintenance expenses have ranged from $72,000 to
$78,000 per year, including some capital expenditures.
• Trash removal costs $135 per month, pest control costs are $195 per month, and
the cost of supplies is estimated at $3,300 per year.
• Most of the apartments are rented on one-year leases, with a typical redecorating
cost of $1,500 per apartment every third year.
• Common area is minimal, and redecorating this space costs about $7,500 every
third year.
• Miscellaneous expenditures are projected at $975 per year.
• The appraiser anticipates that capital replacement will accelerate, and the recon-
structed operating statement should include a separate replacement allowance
for such capital items in addition to normal repair and maintenance expenses.
• Exterior painting, which is estimated to cost $13,950 in the present market, is
scheduled to be done every three years.
• All the apartments have electric stoves, refrigerators, dishwashers, garbage
disposals, and bathroom exhaust fans, so a replacement allowance of $3,899 per
apartment is required. The economic lives of these items vary, but they are esti-
mated to average 10 years.
• The replacement of carpeting costs the owner about $2,700 per unit, and the aver-
age economic life of carpeting is six years.
• The roof is considered to have a 20-year life and a replacement cost of $54,000.
The operating statement shown in Table 28.1 reflects these estimates. The numerical
precision of each entry is approximate, and in most cases the appraiser is rounding to
the closest $5 or $10, which is well within the estimated accuracy of the data.
Sample Multiyear Income and Expense Forecast

Table 28.2 shows a six-year forecast of the income and expenses generated by the
apartment building described in the preceding example. All the techniques described
in these two examples are used to develop a net operating income estimate for the first
year of the forecast. Estimates for the other years are based on existing lease provisions
and expected forecasts regarding lease renewals and growth rates applied to other
income and operating expenses. The annual growth rate conclusions are as follows:

Table 28.1 Southside Apartments: Reconstructed Operating Statement
Income
Potential gross annual income
Rents 11 units @ $1,500/mo. $198,000
12 units @ $1,575/mo. 226,800
16 units @ $1,725/mo. 331,200
16 units @ $600/mo. 345,600
Subtotal $1,101,600
Other income + 4,140
Total potential gross income @ 100% occupancy $1,105,740
Less vacancy and collection loss @ 4% - 44,230
Effective gross income $1,061,510
Operating expenses
Fixed
Real estate taxes $56,100
Insurance
Fire and extended coverage 5,640
Other 2,310
Subtotal $64,050
Variable
Management ($1,061,510 × 0.05) $53,075
Superintendent 50,400
Site maintenance and snow removal 17,700
Electricity 6,600
Other utilities 3,000
Repair and maintenance 75,000
Trash removal ($135 × 12) 1,620
Pest control ($195 × 12) 2,340
Supplies 3,300
Interior decorating* 30,000
Other 975
Subtotal $244,010
Replacement allowance
Exterior paint ($13,950/3) $4,650
Kitchen and bath equipment ($3,900 × 55)/10 21,450
Carpeting ($2,700 × 55)/6 24,750
Roof ($54,000/20 years) 2,700
Subtotal (5.04% of EGI) $53,550
Total operating expenses - $361,610
Operating expense ratio ($361,610/$1,061,510) = 34.07%
Total expenses per unit ($361,610/55) = $6,576 per unit
Net operating income ratio ($699,900/$1,061,510) = 65.93%
* 55 units × $1,500 = $82,500; $82,500 + $7,500 = $90,000; $90,000/3 = $30,000
Applications of the Income Capitalization Approach 507

Table 28.2 Income and Expense Analysis (Multiyear Forecast)
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Income
Potential gross income 1,101,600.00 1,134,648.00 1,168,687.44 1,203,748.05 1,239,860.52 1,277,056.32
Other income 4,140.00 4,264.20 4,392.12 4,523.88 4,659.60 4,799.40
Vacancy and collection loss - 44,229.00 - 45,387.00 - 46,746.00 - 48,150.00 - 49,593.00 - 51,081.00
Effective gross income 1,061,511.00 1,093,525.20 1,126,333.56 1,160,121.96 1,194,927.12 1,230,774.72
Operating expenses
Fixed expenses
Real estate taxes 56,100.00 57,783.00 59,516.49 61,301.97 63,141.03 65,035.29
Insurance
Fire and extended coverage 5,640.00 5,809.20 5,983.47 6,162.99 6,347.88 6,538.32
Other 2,310.00 2,379.30 2,450.67 2,524.20 2,599.92 2,677.92
Variable expenses
Management 53,076.00 54,668.28 56,308.32 57,997.59 59,737.50 61,529.64
Superintendent 50,400.00 52,920.00 55,566.00 58,344.30 61,261.53 64,324.59
Site maintenance and
snow removal 17,700.00 18,231.00 18,777.93 19,341.27 19,921.50 20,519.16
Electricity 6,600.00 7,095.00 7,627.14 8,199.15 8,814.09 9,475.14
Other utilities 3,000.00 3,090.00 3,182.70 3,278.19 3,376.53 3,477.81
Repair and maintenance 75,000.00 77,250.00 79,567.50 81,954.54 84,413.16 86,945.55
Trash removal 1,620.00 1,668.60 1,718.67 1,770.21 1,823.31 1,878.03
Pest control 2,340.00 2,410.20 2,482.50 2,556.99 2,633.70 2,712.69
Supplies 3,300.00 3,399.00 3,500.97 3,606.00 3,714.18 3,825.60
Interior decorating 30,000.00 30,900.00 31,827.00 32,781.81 33,765.27 34,778.22
Other 975.00 1,004.25 1034.37 1065.42 1097.37 1130.28
Replacement allowance
Exterior painting 4,650.00 4,650.00 4,650.00 4,650.00 4,650.00 4,650.00
Kitchen and bath equipment 21,450.00 21,450.00 21,450.00 21,450.00 21,450.00 21,450.00
Carpeting 24,750.00 24,750.00 24,750.00 24,750.00 24,750.00 24,750.00
Roof 2,700.00 2,700.00 2,700.00 2,700.00 2,700.00 2,700.00
Total operating expenses 361,611.00 372,157.83 383,093.73 394,434.60 406,196.97 418,398.24
Operating expense ratio 34.07% 34.03% 34.01% 34.00% 33.99% 33.99%
Total expenses per unit $6,574.74 $6,766.50 $6,965.34 $7,171.53 $7,385.40 $7,607.25
Net operating income $699,900.00 $721,370.37 $743,239.83 $765,687.36 $788,730.12 $812,376.45
Net operating income (rounded) $864,900 $727,368 $743,241 $765,687 $788,730 $812,376
Note: Dollar amounts are shown as two decimal places in this table. Other tables in this chapter are displayed with rounding to
the nearest whole dollar, but amounts are not rounded for internal calculations, which can result in apparent mathematical errors.
• Market rents are anticipated to increase 3% annually, as are the receipts from the
coin-operated equipment in the property.
• Operating expenses are forecasted to increase 3% annually, with the exception of
the superintendent’s salary, which will increase an average of 5% per year, and the
cost of electricity for common areas, which is expected to increase 7.5% annually.

Applications of DCF Analysis
The first two DCF analyses that follow concern a 10,000-sq.-ft. shopping center. The
first example provides an overview of the procedures used to forecast and discount
cash flows into value. The second example shows how to extract a yield rate from a
comparable sale. These are followed by a third example, which illustrates the appli-
cation of DCF analysis to subdivision analysis.
Forecasting and Discounting Cash Flows into Value

The property being appraised is the leased fee interest in a small strip shopping
center consisting of five units of 2,000 square feet each. The following information is
gathered for the DCF analysis:
• Market rents are currently $22.00 per square foot per year, and the appraiser’s
analysis of market rents over the past five years indicates that they have in-
creased at a compound rate of 2.5% per year and that the market expects that
pattern to continue. Market and subject lease terms are triple net.
• Store A’s lease has two years remaining at a rent of $0.91 per square foot per
month, or $10.95 per square foot per year. An interview with the tenant indicates
that the tenant intends to renew the lease at the market rate when the lease expires.
• Store B has a 10-year lease with six years remaining. Current rent is $1.78 per
square foot per month and will increase at a rate of 5% per year or one-half the
change in the consumer price index (CPI), whichever is greater. The CPI is ex-
pected to increase 4% per year over the next five years.
• Stores C, D, and E were recently leased for 10 years. These leases and all new
leases are set at market rent with provisions to keep the rents at market rates
throughout the projection period.
• The landlord is responsible for payment of real estate taxes, exterior maintenance,
management, and capital items. Tenants are responsible for all other expenses.
• Taxes are currently $7,000 per year. The tax assessor reviews and reassesses prop-
erties every three years. The subject property was reviewed one year ago, and
taxes are expected to increase by about $800 with each subsequent review. The
market expects this to remain constant over the next two reviews, i.e., the period
of the income and expense analysis.
• General exterior maintenance, including cleanup and landscaping, costs $2,400
annually. This expense is expected to increase each year by $240.
• Property management fees are set at 5% of the effective gross income.
• A nominal collection loss of 0.5% of gross potential rent is anticipated.
• The roof needs replacement in Year 2 at $30,000 (see Table 28.3). In this simplified
example, no other below-the-line expenses (e.g., leasing costs, tenant improve-
ment costs, or capital replacement expenses) are expected during the five-year
projection period. In a 10-year DCF analysis of this property, forecast expenses
for the cost of replacing tenants would be accounted for as deductions from the
net cash flows in the appropriate years of the projection period.
• The income forecast in Year 6 is used to estimate the resale price of the property
at the end of a five-year projection period. The income for Year 6 is the income for
the first year of operation under the new owner. The net resale price of the prop-

erty in five years is forecast at $3,086,000, calculated as net operating income for
Year 6 capitalized at a terminal capitalization rate of 7% less a sales expense of 3%
of the sale price. In DCF calculations, the terminal capitalization rate is usually
higher than the implied going-in capitalization rate—i.e., the capitalization rate in
Year 1—for various reasons. For example, at the end of the projection period the
improvements will be older, more expensive to maintain, and closer to the end
of their economic lives, which may affect the property’s economic performance
in competition with newer properties. Also, an income projection farther into the
future involves more risk than a projection closer to the present date. Appraisers
use higher terminal rates to reflect the actions of typical market participants.
The appraiser has determined that a leased fee yield rate of 11% is proper and is us-
ing a five-year DCF analysis shown in Table 28.3 to estimate the value of the leased
fee estate.
Table 28.3 Five-Year DCF Analysis of a Shopping Center

Income Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Store A $21,900 $21,900 $46,228 $47,383 $48,568 $49,782
Store B $38,676 $40,610 $42,640 $44,772 $47,011 $49,361
Store C $44,000 $45,100 $46,228 $47,383 $48,568 $49,782
Store D $44,000 $45,100 $46,228 $47,383 $48,568 $49,782
Store E $44,000 $45,100 $46,228 $47,383 $48,568 $49,782
Subtotal $192,576 $197,810 $227,550 $234,305 $241,282 $248,489
Collection loss (0.5%) - $963 - $989 - $1,138 - $1,172 - $1,206 - $1,242
Effective gross income $191,613 $196,821 $226,413 $233,134 $240,076 $247,247
Expenses
Taxes $7,000 $7,000 $7,800 $7,800 $7,800 $8,600
Maintenance $2,400 $2,640 $2,880 $3,120 $3,360 $3,600
Management* $9,581 $9,841 $11,321 $11,657 $12,004 $12,362
Subtotal $18,981 $19,481 $22,001 $22,577 $23,164 $24,562
Net cash flow $172,632 $177,340 $204,412 $210,557 $216,912 $222,685
Replacement allowance $0 $30,000 $0 $0 $0 $0
Net operating income $172,632 $207,340 $204,412 $210,557 $216,912 $222,685
PV of $1 @ 11% factor† × 0.900901 × 0.811622 × 0.731191 × 0.658731 × 0.593451
Present value of
income stream $155,525 $168,281 $149,464 $138,700 $128,726
Subtotal $740,697
Present value of net
resale price‡ $3,085,771 × 0.593451 = $1,831,254
Total leased fee present
value indication $2,571,951
Note: Dollar amounts are rounded in the displayed amounts but not in internal calculations, which can result in apparent mathematical errors.
* Calculated as 5% of effective gross income.
† The present value of $1 is calculated as 1/ (1 + i)n. These factors are preprogrammed in financial calculators and computer spreadsheets.
‡ Calculated as Year 6 net operating income capitalized at a terminal capitalization rate of 7% ($222,685/0.07) less a selling expense of 3% of the
sale price ($3,181,214 × 0.97).

Extracting a Yield Rate from a Comparable Sale
In the subject property’s market area, a 12,000-sq.-ft. strip shopping center with four
tenants was recently purchased for $817,000. Table 28.4 shows the buyer’s projected
income and expense data for the five-year expected holding period and for Year 6,
which is used for the reversion calculation.
Table 28.4 Buyer’s Income and Expense Forecast

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6*
Income
Store 1 $10,000 $10,400 $10,816 $11,249 $11,699 $12,165
Store 2 17,676 18,210 18,888 19,453 19,941 20,835
Store 3 13,151 13,677 14,224 14,793 15,385 16,000
Store 4 19,726 20,515 21,348 22,189 23,077 24,000
Subtotal $60,553 $62,802 $65,276 $67,684 $70,102 $73,000
Expenses
Taxes $6,600 $6,600 $6,600 $7,200 $7,200 $7,200
Maintenance 810 875 953 1,060 1,108 1,210
Management 3,020 3,133 3,256 3,374 3,515 3,625
Collection loss 300 257 243 240 264 250
Subtotal $10,730 $10,865 $16,252 $11,874 $17,287 $12,285
Net cash flow $49,823 $51,937 $43,824 $55,810 $47,615 $60,715
Replacement allowance 0 0 5,200 0 5,200 0
Net operating income $49,823 $51,937 $49,024 $55,810 $52,815 $60,715
* Income in first year under new ownership.
At the end of the five-year projection period, the investor expects to resell the prop-
erty at a terminal capitalization rate of 6.5% less sales costs of 5%, resulting in a forecast
reversion of $887,373. To solve for a yield rate (in this case, an internal rate of return, or
IRR), the appraiser uses a mathematical trial-and-error process in which various over-
all yield rates are tested against the known sale price and cash flows. These repetitive
calculations are simplified with financial calculators and spreadsheet software.
Solving for the expected overall yield rate using a financial calculator and the
cash flows shown in Table 28.5 produces a yield rate of 7.8% (rounded). As an ad-
ditional check, other comparable sales can be analyzed and the resulting yield rates
reconciled to provide additional market support for the overall yield rate estimate.
Table 28.5 Projected Cash Flow in Each Year

Period Cash Flow
0 -$817,000
1 $49,823
2 $51,937
3 $49,024
4 $55,810
5 $52,815 (cash flow)
$887,373 (reversion)

Discounted Cash Flow Analysis in Subdivision Development Analysis
The following example illustrates how discounted cash flow (DCF) analysis may be
applied in subdivision analysis to estimate raw land value when subdivision for a
particular use, such as residential use, is the highest and best use. Subdivision devel-
opment analysis can also be used in feasibility analysis or to estimate the bulk value
of completed homes, condominium units, super pads, or other types of property that
are commonly subdivided.1 The projection of income and absorption in DCF analy-
sis allows appraisers to develop an opinion of value at the point in the development
timeline that is appropriate for the marketability analysis assignment. The inputs
required for the application of subdivision development analysis include
• marketability analysis
• determination of highest and best use
• creation or affirmation of a supportable subdivision development plan
• determination of timing and cost for approval and development
• pricing schedule
• absorption schedule
• phasing of land development and related expenses
• marketing and related holding expenses over the absorption period
• annual real estate taxes and other holding costs, such as maintenance costs for
model homes
• discount rate, including consideration of whether there is a line-item allocation
for entrepreneurial incentive and whether the interest being valued is a property
or an equity position
Note that even when subdivision analysis is appropriate, it should be accompanied
by analysis of sales of comparable properties when that sales data is available. Subdi-
vision analysis is generally better suited for feasibility analysis.
In this case, a 20-acre tract of vacant land is being considered for development as
a 48-lot residential subdivision. It is projected to take six months to plat the subdivi-
sion, achieve entitlements, and construct the infrastructure for the entire subdivision.
After permitting and construction are completed, a two-year absorption period is esti-
mated to market and sell the entire lot inventory. Discounting will be conducted over
all five semiannual phases. The market supports an average retail price of $40,000 per
lot in the first semiannual marketing period. Average lot prices are expected to in-
crease $2,000 in each succeeding six-month period. Expenses are projected as follows:
• Survey, site plan, and development fees over the permitting stage are estimated
to be $35,000 in the first semiannual period. Holding costs for real estate taxes,
the developer’s overhead fee, and other related costs over the permitting and
construction stage are estimated at about $1,300.
• On-site construction costs, including infrastructure improvements within the
subdivision and soft costs, are $10,500 per lot for a total cost of $504,000 spread
over Periods 1, 2, and 4 as shown in Table 28.6.
• Off-site development costs are also required as part of the subdivision approval
by local authorities. This adds $5,000 per lot for a total of $240,000 for off-site
1. See also Don M. Emerson, Subdivision Valuation, second edition (Chicago: Appraisal Institute, 2017).

Table 28.6 DCF Analysis (with No Line-Item Entrepreneurial Incentive)
Semiannual Period
Description 1 2 3 4 5 Total
Beginning lot inventory 0 48 36 24 12
Number of developed lots 48 0 0 0 0 48
Lots sold 0 12 12 12 12 48
Ending lot inventory 48 36 24 12 0
Cumulative lots sold 0 12 24 36 48
Average lot price 0 $40,000 $42,000 $44,000 $46,000
Gross lot sales income $0 $480,000 $504,000 $528,000 $552,000
$2,064,000
Less: Permitting stage costs
Survey, site plan and fees $35,000 $35,000
Holding costs during permitting
and construction $1,300 $1,300
Less: Construction stage costs
On-site direct and indirect
construction costs $384,000 $95,000 $25,000 $504,000
Off-site construction costs $240,000 $240,000
Less: Absorption phase costs
Marketing $33,600 $35,280 $36,960 $38,640 $144,480
Legal/closing $9,600 $10,080 $10,560 $11,040 $41,280
Miscellaneous $3,000 $3,000 $3,000 $3,000 $12,000
Holding costs during absorption $8,400 $6,000 $3,600 $1,200 $19,200
Less: Administration/supervision costs $10,000 $10,000 $10,000 $10,000 $10,000 $50,000
Subtotal expenses $670,300 $159,600 $64,360 $89,120 $63,880 $1,047,260
Net proceeds -$670,300 $320,400 $439,640 $438,880 $488,120
$1,016,740
Present value calculation
Periodic discount rate 11.50% semiannual period
Present value factor 0.896861 0.8043596 0.721398 0.646994 0.580264
Present value per period -$601,166 $257,717 $317,156 $283,953 $283,238 $540,898
Indicated land value $540,898
Rounded $540,000
road and other improvements. These costs will be incurred in the first semiannu-
al period. The holding costs and taxes over the construction period are accounted
for as part of the $1,300 cost of the permitting phase. The absorption costs include
marketing at 7% of gross sales, and legal and closing costs at 2% of gross sales.
• After all lots are built, taxes are accounted for in the holding costs over the
remaining absorption period. Real estate taxes are estimated at $400 per year for
each developed lot in inventory in each period (calculated for the average num-
ber of lots in inventory in each six-month period at $200 per lot). Miscellaneous
costs over the absorption period are $3,000 per six-month period.
• Administration and supervision costs (sometimes referred to as the developer’s fee)
are $10,000 per six-month period, which is appropriate given the relatively small
size of this project.
Table 28.6 shows a DCF analysis of the income and expenses associated with the
projections for the hypothetical project over the 2½-year permitting, construction,
and absorption period. The DCF analysis anticipates that lot sale prices will increase
and expenses will reflect the pattern shown in the 30-month projection. A yield rate
of 23% (or 11.5% over each six-month period) based on market-derived rates from

similar subdivision development sales is used with no line-item entrepreneurial
incentive. (Published surveys from national data providers are also used as sources of
yield rates, which can vary greatly in different economic times.) Accordingly, all the
entrepreneurial incentive associated with the project is accounted for in the selection
of the yield rate. After applying the yield rate to the net proceeds, the indicated land
value for the raw land in “as is” condition at the time of the appraisal can be rounded
to $540,000. A change in any of the variables, including absorption estimates, can lead
to significant variability in the indicated land value.
Note that some market analysts do not discount the negative cash flows in the
beginning of the projection period or use a much lower discount rate, which can be
appropriate when discount rates are properly supported by credible market data.
Similarly, some market participants may prefer to have a separate allocation for
entrepreneurial incentive as a line-item expense in the list of development expenses,
which is possible with the application of a separate discount rate for the remaining
cash flow after entrepreneurial incentive is accounted for. When what is known as
the bifurcated method or split-rate method is used, a separate discount rate is selected in
conjunction with the line-item incentive used for the calculation. Line-item incentive
is a percentage of gross sales, not a yield rate. In Table 28.7, an 8% line-item entrepre-
neurial incentive is included in the DCF analysis. The appropriate yield rate derived
from market data is 15.5% (7.75% per semiannual period) with the given line-item en-
trepreneurial incentive of 8% of gross lot sales each period. The total present value is
rounded to $540,000, the same as the land value conclusion derived using the nonbi-
furcated yield rate method with no line-item entrepreneurial incentive.
As demand decreases for vacant residential lots, absorption periods increase and,
all else being the same, the land value of acreage will be lower where subdivision
development is the highest and best use. Under poor market conditions, especially
with levels of lot prices flat or stagnant and the time frame for market absorption
growing longer, raw land prices will typically decrease. This effect is demonstrated in
Table 28.8, which uses the same figures shown in Table 28.6 except that the required
marketing time to sell the lot inventory has increased and lot values are flat for the
initial marketing period with a lower increase over the last two years.
In this example, the six-step market analysis process reveals that in this recovering
market, after permitting and construction are completed, a four-year absorption pe-
riod will be required to market the entire lot inventory. Discounting will be conducted
over all nine semiannual phases. The market supports a current average retail price
of $40,000 per lot, which is anticipated to remain constant for the first two years (four
periods) of absorption. Beginning in Year 3 of the absorption period, retail lot values
are anticipated to increase by $1,000 each succeeding six-month period. The projected
expenses are the same as those shown in Table 28.6. Initial development costs are
also the same, as are the holding costs over the permitting and construction stage, the
on-site construction costs, and the off-site development costs. Holding costs including
taxes are $1,300 for the permitting phase. After the lots are built, taxes are estimated at
$400 per year for each developed lot in inventory in each six-month period (calculated
for the average number of lots in inventory in each six-month period at $200 per lot).
Miscellaneous costs over the absorption period are the same at $3,000 per six-month
period, together with administrative costs of $10,000 per period. Remaining holding
costs are also unchanged, with marketing sales costs of 7% of gross sales and legal and

closing costs of 2% of gross sales. The yield rate is the same at 23%, or 11.5% for each
six-month period, based on market-derived rates for similar subdivision development
with no line-item entrepreneurial incentive. Although the same yield rate is used in
this example, the higher risk related to market conditions and the longer sellout pe-
riod would typically result in a higher yield requirement for market participants.
In this example the prolonged absorption period and minimal lot value increases
over the absorption period reflect a significantly lower land value conclusion of
$235,000. This amount is about 57% less than the land value supported under the
initial scenario in Table 28.6. In order for the developer to achieve the same rate of
return (23% yield rate), the highest land value supported is $235,000.
Discounted cash flow analysis is useful as a method for checking the reasonable-
ness of value indications derived from other methods applied to estimate the value of
vacant land with development potential, but it does not serve as a suitable substitute
when market land sale data is available for direct sales comparison. Comparing the
value indication derived from DCF analysis with a land value indication derived us-
ing sales comparison allows an appraiser to test the feasibility of a proposed project
Table 28.7 DCF Analysis (with Line-Item Entrepreneurial Incentive)

Semiannual Period
Description 1 2 3 4 5 Total
Beginning lot inventory 0 48 36 24 12
Number of developed lots 48 0 0 0 0 48
Lots sold 0 12 12 12 12 48
Ending lot inventory 48 36 24 12 0
Cumulative lots sold 0 12 24 36 48
Average lot price 0 $40,000 $42,000 $44,000 $46,000
Gross lot sales income $0 $480,000 $504,000 $528,000 $552,000 $2,064,000
Survey, site plan and fees $35,000 $35,000
Marketing $33,600 $35,280 $36,960 $38,640 $144,480
Legal/closing $9,600 $10,080 $10,560 $11,040 $41,280
Miscellaneous $3,000 $3,000 $3,000 $3,000 $12,000
Holding costs during absorption $8,400 $6,000 $3,600 $1,200 $19,200
Less: Administration/supervision costs $10,000 $10,000 $10,000 $10,000 $10,000 $50,000
Less: Line-item entrepreneurial incentive
Percent of gross sales (8%) $0 $38,400 $40,320 $42,240 $44,160 $165,120
Subtotal expenses $670,300 $198,000 $104,680 $131,360 $108,040 $1,212,380
Net proceeds -$670,300 $282,000 $399,320 $396,640 $443,960 $851,620
Present value calculation
Periodic discount rate 7.75%
Present value factor 0.9280742 0.8613218 0.7993706 0.74187525 0.6885153
Present value per period -$622,088 $242,893 $319,205 $294,257 $305,673 $539,940
Rounded $540,000

Table 28.8 Indicated Land Value Under Superior Market Conditions
516
Semiannual Period
Description 1 2 3 4 5 6 7 8 9 Total
Beginning lot inventory 0 48 42 36 30 24 18 12 6
Number of developed lots 48 0 0 0 0 0 0 0 0 48
Lots sold 0 6 6 6 6 6 6 6 6 48
Ending lot inventory 48 42 36 30 24 18 12 6 0
Cumulative lots sold 0 6 12 18 24 30 36 42 48
Average lot price 0 $40,000 $40,000 $40,000 $40,000 $41,000 $42,000 $43,000 $44,000
Gross lot sales income $0 $240,000 $240,000 $240,000 $240,000 $246,000 $252,000 $258,000 $264,000 $1,980,000
Survey, site plan, and fees $35,000 $35,000

Marketing $16,800 $16,800 $16,800 $16,800 $17,220 $17,640 $18,060 $18,480 $138,600
Legal/closing $4,800 $4,800 $4,800 $4,800 $4,920 $5,040 $5,160 $5,280 $39,600
Miscellaneous $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $24,000
Holding costs during absorption (taxes) $9,000 $7,800 $6,600 $5,400 $4,200 $3,000 $1,800 $600 $38,400
Less: Administrative/supervision costs $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $90,000
Less: Line-item entrepreneurial incentive
Percentage of gross sales (0.0%) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0
Subtotal expenses $670,300 $138,600 $42,400 $66,200 $40,000 $39,340 $38,680 $38,020 $37,360 $1,110,900
Net proceeds -$670,300 $101,400 $197,600 $173,800 $200,000 $206,660 $213,320 $219,980 $226,640 $869,100
Present value conclusion
Periodic discount rate (11.5%)
Present value factor 0.896861 0.8043596 0.7213988 0.64699441 0.580264 0.520416 0.466741 0.418602 0.375428
Present value per period -$601,166 $81,562 $142,548 $112,448 $116,053 $107,549 $99,565 $92,084 $85,087 $235,730
Rounded $235,000
Indicated land value under superior
financial conditions $540,000 $27,000 per acre
Land value supported under poor marketing conditions $235,000 $11,750 per acre
Difference -56.5%
and solve for the appropriate discount rate and associated line-item profit allocation. If
the value indication from the DCF analysis is less than the value indicated by the sales
comparison technique, an appraiser may judge the proposed project to not be maxi-
mally productive. Often multiple development scenarios may be applied to provide
support for a highest and best use conclusion.
Developers who are also home builders may perform a subdivision development
analysis that begins with the sale prices of the finished homes. Appraisers may also
use this type of analysis to develop raw land or finished lot values. However, the
cost of constructing the homes must be deducted, and care must be taken in selecting
the discount rate and in allocating the entrepreneurial incentive between land and
improvements in accordance with market practices.
Analysis of Office-Retail Building Investment

The analysis that follows is based on a five-year forecast of the future benefits from
an office-retail building investment. Net operating income is estimated for each year.
Proceeds from resale of the property at the end of the fifth year are also estimated.
Property Analysis
The subject property is a three-story office-retail building with 32,100 square feet of
gross building area. The assignment is to appraise the market value of the leased fee.
The following data on the subject property has been gathered:
• On the first level at street grade, 4,018 square feet of usable area is allocated to a
retail tenant.
• The building also has a ground-floor office with a rentable area of 4,500 square
feet and 4,018 square feet of usable area, indicating a load factor of 12%
[(4,500 - 4,018)/4,018]. The same load factor applies to the rest of the building,
which is office space.
• The building was originally constructed approximately 20 years ago and under-
went a major renovation about two years ago.
• Three tenants currently occupy the building, and a fourth tenant has just signed a
lease.
Lease terms and data on expenditures and other property and market information
are described below and summarized in Tables 28.9, 28.10, and 28.11.
Rationale for the Forecast

The appraiser determines that investors in office buildings similar to the subject proper-
ty typically forecast net operating incomes or equity incomes over a five-year projection
period. To establish a value that will provide for an adequate rate of return to compen-
sate for the perceived risk in the proposed investment, the forecast net operating in-
comes or equity incomes and the reversion are discounted at an appropriate yield rate.
To simulate typical investor analysis, an appraiser
1. Analyzes current income, establishes the market rent level for each tenant’s space,
and forecasts future income for each year of a six-year period based on existing
leases, probable lease renewals at market rent and terms and expected vacancy
and turnover experience.

Figure 28.1 Lease Abstracts
Tenant 1
Creditworthiness High—national credit tenant
Usable area 4,018 sq. ft.
Rentable area 4,500 sq. ft.
Term of lease 10 years (began 2 years ago)
Escalation clause None
Renewal clause Yes—right to renew for another 10 years at market rental rate
Contract/forecast rent $19.50 per sq. ft. per year (rentable)
Tenant 2
Creditworthiness Good
Escalation clause 2% annually
Renewal clause Yes—right to renew at market rental rate
Contract/forecast rent $15.75 per sq. ft. per year (rentable)
Tenant 3
Creditworthiness Average
Escalation clause 3.5% annually
Renewal clause Right to renew for 5 additional years at $20 per sq. ft. per year fixed
Contract/forecast rent 3 years at $17 per sq. ft. per year, 5 years at $20 per sq. ft. per year (rentable)
Tenant 4
Creditworthiness Average
Term of lease 7 years
Escalation clause 3.5% annually
Renewal clause None
Contract/forecast rent $16 per sq. ft. per year (rentable)
Table 28.9 Summary of Forecast Contract Rental Income

Tenant 1 $87,750 $87,750 $87,750 $87,750 $87,750 $87,750
Tenant 2 $244,125 $249,008 $253,988 $259,067 $264,249 $269,534
Tenant 3 $129,200 $133,722 $138,402 $152,000 $152,000 $152,000
Tenant 4 $38,400 $39,744 $41,135 $42,575 $44,065 $45,607
Potential income $499,475 $510,224 $521,275 $541,392 $548,064 $554,891

Table 28.10 Total Forecast Operating Expenses Over Projection Period
Property taxes $64,000 $66,560 $69,222 $71,991 $74,871 $77,866
Property insurance $6,900 $7,107 $7,320 $7,540 $7,766 $7,999
Property management $21,491 $22,083 $22,692 $23,662 $24,112 $24,574
Common area maintenance $97,500 $100,425 $103,438 $106,541 $109,737 $113,029
Total operating expenses $189,891 $196,175 $202,672 $209,734 $216,486 $223,468
Table 28.11 Forecast Operating Expense Reimbursements Over Projection Period

Tenant 1 $28,257 $29,175 $30,125 $31,159 $32,144 $33,163
Tenant 2 $31,454 $34,617 $37,888 $41,451 $44,845 $48,355
Tenant 3 $0 $0 $0 $0 $0 $0
Tenant 4 $3,070 $3,560 $4,067 $4,618 $5,144 $5,687
Total operating expense
reimbursements $62,781 $67,352 $72,080 $77,228 $82,133 $87,205
2. Forecasts other income, including income from escalation clauses contained in

existing leases and expected escalation provisions in new leases.
3. Forecasts future property expenses after analyzing historical operating expenses, the
experience of competitive properties, and the current budget for the subject property.
4. Estimates net operating income.
5. Estimates property reversion.
6. Forecasts mortgage debt service, when appropriate, based on existing or pro-
posed financing terms.
7. When appropriate, estimates the equity income to be generated by the property
in each year of the forecast projection period.
8. Estimates the reversionary benefits to be received at the end of the projection
period (in this case, Year 6 IO using an 8.5% terminal capitalization rate). If a sig-
nificant capital expenditure or change in leases in the sixth year—i.e., the year of
reversion—is expected, the projection period may be extended to incorporate this
event. This will ensure that the analysis is not unduly influenced by an unusual
event in the reversion year used to calculate the reversion value.
In developing an opinion of market value for the leased fee, an appraiser must ap-
ply these steps in a manner that reflects the thinking of market participants. In this
sample application, the appraiser begins by assembling pertinent information on
comparable office buildings in the same market as the subject property. To verify the
data, the appraiser interviews one of the participants, preferably the buyer, to deter-
mine the net operating income (or equity income) forecast of each building owner
associated with each comparable property.

Tenants and Leases in the Subject Property
The following information has been gathered about the tenants:
• Tenant 1, a national restaurant tenant, is located on the first floor (4,018 usable square
feet). The tenant moved in shortly after renovation two years ago and pays $19.50 per
square foot of rentable area per year on an absolute net lease basis fixed for 10 years.
This tenant has the right to renew for another 10 years at market rent and terms.
• Tenant 2, a law firm, occupies 4,911 square feet of usable area on the first floor
and 8,929 square feet of rentable area on the second floor. This local firm has
experienced considerable growth over the past 10 years and moved to the subject
building to accommodate this expansion. The lease began two years ago and has
a 10-year term with an option to renew at market rent. The tenant is currently
paying rent of $15.75 per square foot of rentable area per year, with an expense
stop of $4.25 per square foot. The lease calls for the rent to increase at 2% per year.
• Tenant 3 occupies 6,786 square feet of usable area on the third floor and pays
$17.00 per square foot of rentable area per year on a gross full-service basis. An es-
calation clause provides for a 3.5% annual increase in rent over the five-year term
of the lease, which began two years ago. This tenant has an option to renew for an-
other five years at a fixed rent of $20 per square foot of rentable area per year full
service and has indicated an intention to do so. At the time of renewal, the owner
will provide the tenant a tenant improvements (TI) allowance of $4 per square foot
of rentable area to refresh the space. The leasing commission at the time of renewal
is estimated at 2% of total contract rent, and it is due in full at the time of renewal.
• The remainder of the space, 2,143 square feet of usable area on the third floor,
has just been leased to Tenant 4 at $16 per square foot of rentable area per year,
with rents escalating at 3.5% per year and an expense stop of $5.00 per square
foot. The term of the lease is seven years. For this new tenant, the TI allowance
is $12 per square foot of rentable area, and the leasing commission is 4% of total
contract rent (entire term). The commission is paid during the first month.
Relevant lease information is summarized in Figure 28.1, and the rental income for
each lease is forecast in Table 28.9.
Forecast Operating Expenses and Reimbursements

Property taxes are $64,000, due at the end of the year. Property insurance is $0.23 per
square foot of rentable area per year. Property management is 4% of total potential
income. Common area maintenance (CAM) is $3.25 per square foot of rentable area
per year. Property taxes are expected to grow at 4% per year, while insurance and
CAM are expected to grow at 3% per year over the next 10 years.
The total operating expenses for each year in the six-year projection period are
calculated in Table 28.10, and operating expense reimbursements are summarized in
Table 28.11.
Capital Expenses
At the time of renovation, the owners elected to postpone replacement of the roof.
A capital expenditure of $40,000 will be required in about four years to replace the
roof. In Table 28.12, the leasing expenses and capital costs are listed in the year those
charges are incurred.

Table 28.12 Leasing Expenses and Capital Costs
Leasing commissions $11,949 $15,200
Tenant improvements $28,800 $30,400
Capital costs $40,000
Other Research
Other research has uncovered the following data:
• Investors allocate a vacancy allowance of 5% of total potential income, even
when a property is fully occupied.
• Reversionary capitalization rates for similar buildings are approximately 8.5%.
• A five-year projection period is typically used for analysis, and selling expenses
are estimated at approximately 3%.
• Investors are typically using a 9.5% discount rate when discounting the cash
flows before debt service and the reversion to arrive at a value indication.
• Market participants are not deducting a replacement allowance before calcu-
lating net operating income, but they are deducting leasing costs and capital
expenses before calculating cash flow before debt service.
In Table 28.13, cash flow before debt service is calculated for each year of the five-year
projection period along with the sixth year for the purposes of calculating the reversion.
Reversion Calculation
The resale price is forecast by applying an 8.5% overall capitalization rate to the net
operating income for the year after the projection period (Year 6). The net operating
income for Year 6 represents the projected income for Year 1 under the next owner. In
this application, sales expenses of 3% are deducted to determine the net resale price:
6th Year IO
= Reversion Value
Terminal Capitalization Rate
$385,363
= $4,533,682
0.085
Reversion Value - Selling Expenses = Reversion
$4,533,682 - $136,010 = $4,397,672
Investor’s Desired Rate of Return

The market value of the leased fee can be estimated by calculating the present value
of the net cash flow for each year of the five-year projection period and adding the
present value of the cash flow from the sale of the property in Year 6 (the net resale
price). Suppose the typical investor requires an overall yield rate (YO) of 9.5%. At a
9.5% discount rate, the present value of the cash flow before debt service and rever-
sion is $4,081,728 (see Table 28.14). This means that the investor would expect to earn
a 9.5% rate of return if $4,081,728 is paid for the property.

Table 28.13 Forecasting Cash Flows
Income
Tenant 1 $87,750 $87,750 $87,750 $87,750 $87,750 $87,750
Tenant 2 244,125 249,008 253,988 259,067 264,249 269,534
Tenant 3 129,200 133,722 138,402 152,000 152,000 152,000
Tenant 4 38,400 39,744 41,135 42,575 44,065 45,607
Potential rental income $499,475 $510,224 $521,275 $541,392 $548,064 $554,891
Other income $0 $0 $0 $0 $0 $0
Expense reimbursements
Tenant 1 $28,257 $29,175 $30,125 $31,159 $32,144 $33,163
Tenant 2 31,454 34,617 37,888 41,451 44,845 48,355
Tenant 3 0 0 0 0 0 0
Tenant 4 3,070 3,560 4,067 4,618 5,144 5,687
Total expense reimbursements $62,781 $67,352 $72,080 $77,228 $82,133 $87,205
Total potential income $562,256 $577,576 $593,355 $618,620 $630,197 $642,096
Vacancy & collection
allowance (5%) - 28,113 - 28,879 - 29,668 - 30,931 - 31,510 - 32,105
Effective gross income $534,143 $548,697 $563,687 $587,689 $598,687 $609,991
Operating expenses
Property taxes $64,000 $66,650 $69,222 $71,991 $74,871 $77,866
Property insurance 6,900 7,107 7,320 7,540 7,766 7,999
Property management 22,490 23,103 23,734 24,745 25,208 25,684
Common area maintenance 97,500 100,425 103,438 106,541 109,737 113,029
Total operating expenses $190,890 $197,285 $203,714 $210,817 $217,582 $224,578
Net operating income (IO) $343,253 $351,412 $359,973 $376,872 $381,105 $385,363
Leasing commissions 11,949 15,200
Tenant improvements 28,800 30,400
Capital costs 0 0 0 0 40,000
Cash flow before debt service $302,504 $351,412 $359,973 $291,272 $381,105
Table 28.14 Discounting of Income Streams and Reversion

Period Cash Flow before Debt Service Present Value Factors Present Value
Year 1 $302,504 0.913242 $276,259
Year 2 $351,412 0.834011 $293,081
Year 3 $359,973 0.761654 $274,174
Year 4 $291,272 0.695574 $202,601
Year 5 $381,105 0.635228 $242,089
Reversion proceeds $4,397,672 0.635228 $2,793,524
Total present value $4,081,728

Additional Analysis
Although property value was estimated by discounting the projected cash flow for
each year rather than by applying a formula to develop an overall capitalization
rate, an overall capitalization rate is implied in the solution. In this case, the overall
capitalization rate (RO) for Year 1 is 8.41%, calculated by dividing Year 1 net operating
income by the discounted present value ($343,253/$4,081,728). This overall capi-
talization rate is lower than the 8.5% rate applied to projected Year 6 net operating
income to estimate the resale price.2
This example illustrates the need to consider carefully the anticipated pattern
of net operating income when selecting an overall capitalization rate to be used in
direct capitalization or a property model for yield capitalization. Capitalization rates
can differ significantly for properties with different patterns of net operating income
beyond the first year and different resale potential. The absence of a regular income
pattern does not necessarily mean that detailed DCF analysis is the only method that
should be considered. An appraiser may discover that one of the standard valuation
models can be adjusted to compensate for a deviation from the regular income pat-
tern, or that a special valuation model can be devised to solve the problem at hand.
2. See D. Richard Wincott, “Terminal Capitalization Rates and Reasonableness,” The Appraisal Journal (April 1991): 253-260. If, over the projection
period, a substantial capital expenditure is allocated for the refurbishment or renovation of an aging property, RN may equal or be less than RO.
Such a relationship between RN and RO is also likely when current income exceeds market levels or when current market conditions are inferior
to those anticipated at the end of the projection period.

The Cost Approach 29
Like the sales comparison and income capitalization approaches, the cost approach is
based on market comparisons. In the cost approach, appraisers compare the replace-
ment cost of the subject improvements to the cost to develop similar improvements as
evidenced by the cost of construction of substitute properties with the similar utility
as the subject property. The estimate of development cost is adjusted for market-ex-
tracted losses in value caused by the age, condition, and utility of the subject improve-
ments or for locational problems. The land value as if unimproved is then added,
usually based on comparison with sales of comparable sites with the same or a similar
highest and best use. The sum of the value of the land and the improvements is ad-
justed for any existing property rights (e.g., leased fee, leasehold interests) included
with the subject property, which are implicit in the two other approaches to value.
In estimating land value, appraisers must be aware of the theory of consistent use,
which holds that land cannot be valued on the basis of one use while the improvements
are valued on the basis of another use. Consistent use is most often an issue when there
are interim or transitional uses of land. For example, a property in transition from one
use to another cannot be valued on the basis of one immediate use for land and another
use for improvements because to do so would be inconsistent with elements of valua-
tion. The improvements must enhance the value of the land or pay the penalty (in the
form of depreciation) for any misuse of the land. A dwelling that may have many years
of remaining life for a residential use cannot enhance the value of the land for which the
immediate highest and best use would be for redevelopment with a commercial use.
Buyers of real property may judge the value of an existing property not only by
considering the prices and rents of similar properties, but also by comparing its value
to the cost to develop a new property with optimal physical condition and functional
utility. For an existing property, buyers typically estimate the costs (e.g., capital
expenditures, lease-up costs) required to bring the existing property to the optimal
physical condition and functional utility.
It is important to note that the cost approach is a theoretical breakdown, or
componentization, of the subject property. The real property components include
land and building and site improvements. In order to reconcile the cost approach
to the other two approaches to value, an appraiser must also make an adjustment
for any in-place leases (e.g., unamortized leasing commissions and tenant improve-
ment costs, lost revenue during downtime, the contribution or detriment, if any, of
the existence of the lease, and the present value of the above- or below-market rent
variance). Understanding the concept of componentization is important because the
cost approach makes explicit what is otherwise implicit in the other two approaches
to value. For example, external obsolescence is estimated in the cost approach but not
required in applying the income capitalization and sales comparison approaches. The
cost approach is also important because it often serves as a basis of recording fixed
assets for financial reporting. (See Chapter 36.) The allocation of land and improve-
ments affects the annual depreciation expense.
To apply the cost approach, an appraiser estimates the market’s perception of the
value difference between the property improvements being appraised and a newly
constructed building with optimal utility (i.e., the ideal improvement identified in
highest and best use analysis). In its classic form, the cost approach produces an
opinion of the value of the fee simple estate (i.e., as vacant). If the purpose of the ap-
praisal is to estimate the value of an interest other than fee simple, an adjustment will
be required. For example, a property rights adjustment could be made as a lump-sum
adjustment at the end of the cost approach. This would be particularly important
when the interest appraised is the leased fee encumbered by a long-term lease that
does not reflect market terms.
In applying the cost approach, an appraiser must distinguish between two cost
bases—reproduction cost and replacement cost—and use one of the two consistently
throughout the analysis. The market and physical condition of the appraised prop-
erty usually suggest whether an exact replica of the subject property (reproduction
cost) or a substitute property of comparable size and use (replacement cost) would
be the basis of a more suitable comparison. The term modern equivalent asset is used in
international valuation standards to describe an asset that provides “similar function
and equivalent utility to the asset being valued” rather than a replica designed and
constructed using current materials and methods.1
Appraisers estimate the cost to construct existing structures and site improve-
ments (including direct costs, indirect costs, and an appropriate entrepreneurial
incentive or profit) using one of three traditional methods:
• The comparative-unit method (or calculator method)
• The unit-in-place method (or segregated cost method)
• The quantity survey method
Appraisers then deduct all depreciation in the property improvements from the cost
of the new structure as of the effective appraisal date. (Outside the United States, the
term depreciated replacement cost method is often used to describe the application of the
cost approach in this manner.) The amount of depreciation present is estimated using
one or more of three fundamental methods:
• The market extraction method
1. International Valuation Standards Council (IVSC) Glossary, s.v., “Modern Equivalent Asset.” Available online at www.ivsc.org/standards/glossary.
Accessed on February 28, 2020.

• The economic age-life method
• The breakdown method
When the value of the land is added to the cost of the improvements less deprecia-
tion, the result is the indicated value of the fee simple estate by the cost approach.
Figure 29.1 illustrates the outline of the cost approach in its classic format, and
this chapter explains the fundamental appraisal concepts that support this approach
to value. Chapters 30 and 31 discuss the specifics of building cost and depreciation
estimates—i.e., the essential techniques applied to develop a credible indication of
value using the cost approach.
Figure 29.1 Classic Cost Approach Analysis

Estimated cost new (replacement cost or reproduction cost)
Direct costs
Indirect costs
Entrepreneurial incentive (or profit)
Subtotal
Less: Depreciation
Physical deterioration
Deferred maintenance
Incurable short-lived items
Incurable long-lived items
Subtotal
Functional obsolescence
Curable
Item 1
Item 2
. . .
Incurable
Item 1
Item 2
. . .
Subtotal
External obsolescence
Location
Market
Subtotal
Subtotal
Plus: Depreciated cost of site improvements
(including entrepreneurial incentive or profit)
Plus: Estimated land value
Value indication of fee simple estate by cost approach
Property rights adjustment
Rent-up adjustment
Value indication of cost approach for the interest being appraised

Substitution
The principle of substitution is basic to the cost approach. This principle affirms that a
knowledgeable buyer would pay no more for a property than the cost to acquire a sim-
ilar site and construct improvements of similar desirability and utility without undue
delay. In the cost approach, existing properties can be seen as substitutes for the prop-
erty being appraised, and their value is also measured relative to the value of a new,
optimal property. In short, the reproduction or replacement cost of property improve-
ments on the effective date of the appraisal plus the accompanying land value provides
a measure against which values for similar improved properties may be judged.
Supply and Demand

Shifts in supply and demand cause values and prices to increase or decrease. As a
result, a single property may have different values over time. If costs do not shift in
proportion to price changes, the construction of buildings will be more or less profit-
able and the value of existing buildings will increase or decrease commensurately. If
costs of production increase faster than values, new construction will be less profit-
able or may not be financially feasible. In other words, the incentive for developers
to build is directly tied to supply and demand. Of course, the costs to be considered
would include not just construction cost, but also the cost to acquire land.
Contribution
The principle of contribution, which holds that the value of an individual component
of a property is measured in terms of how much it contributes to the value of the
property as a whole, is integral to the application of the cost approach. The various
methods of estimating building costs are based on the contributions of the individual
components of a property. International valuation standards identify the summation
method as a technique used in the cost approach to value an entire asset by adding
the separate values of the asset’s component parts.2
Conversely, the principle of contribution implies that the value of a component
may be measured as the amount its absence would detract from the value of the
property as a whole. From this perspective, the estimation of depreciation can be seen
as an application of the principle of contribution.
In the application of the cost approach, the amount each component contributes
to the value of the property as a whole is measured in relation to the highest and best
use of the property. For example, if the highest and best use of the property is for the
conversion of the existing improvements to an alternative use, items that must be
changed for the property to achieve its highest and best use would suffer from some
form of depreciation.
In the cost approach, the effect on value of a deficiency or superadequacy is ad-
dressed in the estimate as a form of depreciation known as functional obsolescence. The
deficiency or superadequacy can be identified by comparing the existing improvements
with the ideal improvement and then treated by making a deduction from the cost of
the improvements. As the improvements depreciate, the site often contributes a higher
percentage of total property value. As the ratio of land value to total property value ap-
2. IVSC Glossary, s.v., “Summation Method.”

proaches 100%, the likelihood that the improvements will be demolished or remodeled
and that the property will be redeveloped to a new highest and best use increases.
Externalities
The construction cost and market value of a property may be affected differently by
conditions that are external to the property. For example, externalities such as infla-
tion or natural disasters may increase material and labor costs without a correspond-
ing increase in market values. Real estate values do not always run parallel with
other economic trends. On the other hand, an external event such as the completion
of a sewer line may increase the value of the land associated with a property but have
no effect on the cost of the improvements. Gains or losses in value caused by exter-
nalities may accrue to the land, the site, the building, or the property as a whole. Ris-
ing construction costs can significantly affect the market value of new construction
and, in turn, the demand for and market value of older, substitute properties.
In the cost approach, a loss in building value due to external causes is attributed
to external obsolescence, which is covered in detail in Chapter 31. Externalities can
be either temporary or permanent and may work in positive and negative directions
over the life of a building improvement.
Highest and Best Use

In highest and best use analysis, an appraiser analyzes the site as though vacant and
available to be developed to its highest and best use. An ideal improvement or course
of development is identified, if the market allows for a specific highest and best use
conclusion. If the site of the subject property is improved, the appraiser also compares
the existing improvements to the ideal improvements or to the current standards
found in the market area for the general property type if that is as specific as the high-
est and best use conclusion can be given the market support. Existing improvements
have a value equal to the amount they contribute to the site, or they may penalize the
property value if they have outlived their usefulness. This penalty is often measured
by the cost to raze and remove the obsolete improvements from the site.
Existing improvements are rarely identical to the ideal improvements, unless they
are new construction, and, even then, they may be an overimprovement or underim-
provement by comparison with the ideal. For example, a new building that is poorly
designed for the market is worth less than its cost because of the functional obsoles-
cence in its design, which is discussed in more detail later in this chapter. An accurate
and detailed analysis of highest and best use is critical to the cost approach because the
comparison of the existing improvement and the ideal improvement based on the high-
est and best use identifies any forms of depreciation that are present in the building.
Nonconforming uses can present special valuation challenges. If, for example, an
existing property is a nonconforming use because the improvements exceed the bulk
regulations allowed by zoning and the existing structure could not be rebuilt or mod-
ified if it were damaged or destroyed, this can affect the highest and best use. The
appraiser needs to consider any additional depreciation that may be caused by the
existence of the square footage above that permitted by zoning. The cost approach is
typically not the best approach to apply in this situation because buyers would not
likely consider the construction of a nonconforming improvement on vacant land as
an alternative.

Stabilization
In its classic form the cost approach estimates fee simple value without consideration
of the costs or benefits associated with leasing. However, adjustments can be made
to account for the value difference between a fee simple property and a leased fee,
depending on the property rights being appraised. Appraisers may need to consider
the holding costs that accrue during the leasing phase of property development along
with other indirect costs such as leasing commissions, marketing costs, and rent con-
cessions. Tenant finish costs may also be necessary to achieve stabilized occupancy
and, if so, they must be added as a cost when valuing a leased fee.
In the appraisal of a leased fee property with rents that are higher or lower than
market rents and terms, the value developed by the cost approach may require ad-
ditional adjustment to reflect the specific situation of the subject property. As an alter-
native, factors such as tenant finish costs and above- or below-market rents could be
recognized in the process of reconciling the value indications of the other approaches
to value.

In any market, the value of a building can be related to its cost. The cost approach
is particularly important when a lack of market activity limits the usefulness of the
sales comparison approach and when the property to be appraised—e.g., a one-unit
residence—is not amenable to valuation by the income capitalization approach. Be-
cause cost and market value are usually more closely related when improvements are
new, the cost approach is more important in estimating the market value of new or
relatively new construction. The approach is especially persuasive when land value
is well supported and the improvements are new or suffer only minor depreciation
and, therefore, approximate the ideal improvement that is the highest and best use of
the land as though vacant.
The cost approach can sometimes be applied to older properties given adequate
data to measure depreciation. However, investors or purchasers of older buildings
considering an acquisition may be more concerned about expenditures that they will
need to make after the purchase to make the property suitable to their needs than
they are by the calculation of replacement or reproduction cost and depreciation.
The cost approach may be used to develop an opinion of market value (or some
other type of value that an appraisal assignment may require such as use value or fair
value) of proposed construction, special-purpose or specialty properties, and other
properties that are not frequently exchanged in the market. Buyers of these properties
often measure the price they will pay for an existing building against the cost to build
less depreciation or against the cost to purchase an existing structure and make any
necessary modifications. If sale and rental data for comparable properties is not avail-
able, current market indications of the depreciated cost of an existing building (or the
costs to acquire and refurbish the building) would be the best reflections of market
thinking and, thus, of market value.
When the physical characteristics of comparable properties differ significantly,
the relative values of these characteristics can sometimes be identified more precisely
with the cost approach than with the sales comparison approach. Because the cost ap-
proach starts with the cost to construct a replica or a substitute property with optimal
physical and functional utility, it can help an appraiser determine accurate adjust-

ments for physical differences in comparable sale properties. If, for example, an ap-
praiser must make an adjustment for inadequate elevators in a comparable property,
the cost to cure the deficiency can be used as a basis for this adjustment. Thus, the
cost approach provides appraisers with data to use both in estimating depreciation
and in deriving an adjustment to apply in the sales comparison approach.
The cost approach is especially useful when building additions or renovations
are being considered, which is a key issue in highest and best use analysis. The ap-
proach can be used to estimate whether the cost of an improvement, including an
entrepreneurial incentive, will be recovered through an increased income stream
or in the anticipated sale price. The analysis of feasibility rent can help identify and
prevent the construction of overimprovements.
Because the cost approach requires that land and improvements be valued sepa-
rately, it is also useful in appraisals for insurance purposes, when uninsurable items
must be segregated from insurable items. In valuation for accounting purposes, the
cost approach is applied to estimate depreciation for income tax purposes. In cases
where land value tends to make up a considerable portion of overall property value
(such as agricultural properties or high-exposure commercial outparcels), the cost
approach can take on greater significance in the reconciliation of the value indica-
tions of all the approaches to value applied because the cost approach is the only one
requiring a separate conclusion of land value.
Finally, an estimate of probable building and development costs is an essential
component of feasibility studies, which test the investment assumptions on which
land use plans are based. A proposed development is considered financially feasible
when market value exceeds total building and development costs plus a reasonable,
market-supported estimate of entrepreneurial incentive (i.e., the anticipated profit
necessary for an entrepreneur to proceed with the project).
A higher value indication from the application of the cost approach than from the
sales comparison or income capitalization approaches may suggest that the real es-
tate development is not economically feasible. If the cost approach indicates a higher
value for an existing building, then an appraiser may need to take a closer look at
one or more of the inputs—land value, current cost, depreciation, or entrepreneurial
incentive. For older properties or properties in fluctuating markets, an inaccurate
estimate of the remaining economic life could cause depreciation to be understated
resulting in a higher value indication in the cost approach. When a higher or lower
value is produced in the cost approach, that value indication is usually compared
against the results of one or more of the other approaches and explained in the final
reconciliation step of the valuation process.
When improvements are considerably older or do not represent the highest and
best use of the land as though vacant, the physical deterioration, functional obsoles-
cence, and external obsolescence may be more difficult to estimate. Furthermore, rel-
evant comparable data may be lacking or the data available may be too diverse to indi-
cate an appropriate anticipation of entrepreneurial profit (i.e., the profit actually earned
from a completed project). These conditions may make the cost approach less reliable.
One of the weaknesses of the cost approach, from an investment perspective, is
the assumption that newly constructed improvements are immediately available on
the date of the appraisal. An investor looking at options for an immediate purchase
may consider the months or years required to develop and construct a new property

to be an unacceptable delay. From the perspective of that investor, the cost approach
would have no relevance.
Another problem arises if the asset being valued is clearly obsolete. According to
the principle of substitution, a buyer would pay no more for a property than the cost
of buying or building a property of similar utility. Therefore, a property that has little
utility would not be recreated, and the value of the the improvements would be mini-
mal or nothing. Any salvage value that remains is likely to be discovered in the test of
financial feasibility in the analysis of the highest and best use of the subject property.
Even though the cost approach may have an advantage over the sales compari-
son and income capitalization approaches when reliable data on comparable sales
and rents is scarce, that same lack of data can weaken the credibility of the estimate
of land value that is an essential step in the application of the cost approach. All the
appraisal methods used in land valuation depend on sales comparison and income
capitalization techniques.
Appraisers must remember that the cost approach initially results in an indica-
tion of the value of the fee simple estate. To value real estate held in leased fee or
property subject to other partial interests, appraisers must make adjustments to
reflect the specific real property rights being appraised, such as a leased fee interest.
An example of adjusting for property rights is shown in Chapter 31.
Procedure
After gathering all relevant information and analyzing data for the market area, site,
and improvements, an appraiser follows a series of steps to derive a value indication
by the cost approach. An appraiser will
1. Estimate the value of the site as though vacant and available to be developed to
its highest and best use.
2. Determine which cost basis is most applicable to the assignment: reproduction
cost or replacement cost.
3. Estimate the direct (hard) and indirect (soft) costs of the improvements as of the
effective appraisal date.
4. Estimate an appropriate entrepreneurial incentive from analysis of the market.
5. Add the estimated direct costs, indirect costs, and entrepreneurial incentive to
arrive at the total cost of the improvements.
6. Estimate the amount of depreciation in the improvements and, if necessary, al-
locate it among the three major categories:
• Physical deterioration
• Functional obsolescence
• External obsolescence
7. Deduct estimated depreciation from the total cost of the improvements to derive
an estimate of their depreciated cost.
8. Estimate the contributory value of any site improvements that have not already
been considered. (Site improvements may be appraised at their contributory
value—i.e., directly on a depreciated-cost basis—but may be included in the
overall cost calculated in Step 3 and depreciated if necessary.)

9. Add land value to the total depreciated cost of all the improvements to develop
an indication of the market value of the fee simple interest in the real property.
10. If appropriate, adjust for the property interest being appraised to derive the indi-
cated value of the specified interest in the property.
11. If the property will experience net income shortfalls during a lease-up period,
then calculate a rent-up adjustment to account for the cost of leasing (distinct
from leasing commissions).
12. Adjust for personal property (e.g., furniture, fixtures, and equipment) or intan-
gible assets that are included in the appraisal.
Land Value
In the cost approach, the estimated market value of the land or site as though vacant
is added to the depreciated cost of the improvements. The value of the land is based
on its highest and best use. Land value can be estimated using various techniques,
which are discussed in Chapter 19. Appraisers must remember that the land value
estimates produced with these techniques reflect the value of the fee simple estate.
If a land lease is involved and it is not at market terms, this would change the rights
appraised from fee simple to either leasehold or leased fee depending on the purpose
of the assignment.
Reproduction Cost and Replacement Cost

The cost to construct an improvement on the effective appraisal date may be devel-
oped as either the estimated reproduction cost or estimated replacement cost of the
improvement. The theoretical base (and classic starting point) for the cost approach
is reproduction cost, but replacement cost is more commonly used because it may be
easier to obtain and can reduce the complexity of depreciation analysis. An important
distinction must be made between the terms:
• Reproduction cost is the estimated cost to construct, as of the effective appraisal
date, an exact duplicate or replica of the building being appraised, insofar as
possible, using the same materials, construction standards, design, layout, and
quality of workmanship, and embodying all the deficiencies, superadequacies,
and obsolescence of the subject improvements.
• Replacement cost is the estimated cost to construct, as of the effective appraisal
date, a substitute for the building being appraised using contemporary materials,
standards, design, and layout. When this cost basis is used, some existing obso-
lescence in the property may be cured. Replacement cost may be the only alterna-
tive if reproduction cost cannot be estimated.
The decision to use reproduction cost or replacement cost is often dictated by the
age of the structure, its uniqueness, and any difference between its intended use at
the time of construction and its current highest and best use. In theory, the use of ei-
ther reproduction cost or replacement cost should yield the same indication of value
after proper application. If reproduction cost or replacement cost is used inconsis-
tently, double-counting of items of depreciation and other errors can be introduced
into the analysis. The cost basis selected for a particular appraisal should be clearly
identified in the report to avoid misunderstanding and must be applied consistently
throughout the cost approach to avoid errors in developing an opinion of value.

The use of replacement cost can eliminate the need to measure some, but not all,
forms of functional obsolescence such as superadequacies and poor design. Re-
placement structures usually cost less than identical structures (i.e., reproductions)
because they are constructed with materials and techniques that are more modern,
more readily available, and less expensive in the current market. Also, correcting
deficiencies may result in lower costs. Thus, a replacement cost estimate is usually
lower and may provide a better indication of the existing structure’s contribution
to value. A replacement structure typically does not suffer functional obsolescence
resulting from superadequacies. However, if functional problems persist in the hy-
pothetical replacement structure, an amount must be deducted from the replacement
cost. Estimating replacement cost generally simplifies the procedure for measuring
depreciation in components of superadequate construction. An example of functional
obsolescence would be the absence of a desirable feature such as air-conditioning
in an existing improvement in a market where this feature is standard. This form of
obsolescence would be corrected in a replacement building.
Estimating reproduction cost can be complicated because the improvements may
include materials that are no longer available and construction standards or codes
may have changed. Nevertheless, reproduction cost usually provides a better basis for
measuring depreciation from all causes when that sort of measurement is necessary.
Cost Estimates
To develop cost estimates for the total building, appraisers must consider direct costs
(also known as hard costs) and indirect costs (also known as soft costs). Both direct and
indirect costs are essential to a reliable cost estimate. (The traditional data sources and
appraisal techniques used to estimate building costs are discussed in Chapter 30.)
Direct construction costs include the costs of material and labor as well as the
contractor’s profit required to construct the improvement on the effective appraisal
date. The entrepreneurial incentive or profit is separate and apart from the contractor’s
or developer’s profit. The overhead and profit of the general contractor and various
subcontractors are usually part of the construction contract and therefore are direct
costs that should always be included in the cost estimate. In more complex projects,
where multiple contractors, construction staging, or other complications are involved,
a management fee may be required. Indirect costs are expenditures or allowances that
are necessary for construction but are not typically part of the construction contract.
These costs can include, but are not limited to, the cost of architectural and engineering
services, loan origination fees, carrying costs during construction, title insurance fees,
appraisal and legal fees, leasing and marketing costs, and developer’s overhead and
anticipated profit. Because the entrepreneur provides the inspiration, drive, and coor-
dination necessary to the overall project, the cost approach should include an appro-
priate entrepreneurial incentive or anticipated profit, which is discussed later in this
chapter. A construction contingency is not usually a soft cost but rather a hard cost.
The quality of materials and labor greatly influences costs, and appraisers should
be familiar with the costs of the materials used in the property being appraised. A
building can cost substantially more than is typical if items such as walls and win-
dows are overinsulated or thicker slabs are used to accommodate greater floor loads.
Many newer structures contain elements that may not be found in older buildings
with which they compete. At one time the market may have considered features such

as internet connectivity, networking and telecommunications capabilities, and ad-
equate, reliable power in “smart” office buildings to be high-tech overimprovements.
These features may not have contributed as much value as they cost at the time of
installation, but as demand for these building materials and features continues to
increase so does their contribution to value.
The competitive situation in the local market can also affect cost estimates. Ac-
tual contractor bids based on the same set of specifications can vary substantially. A
contractor who is working at capacity is inclined to make a high bid, while one who
needs the work is likely to submit a lower figure. The items cited in the Table 29.1 in-
clude typical costs incurred in a balanced market. In markets that are out of balance,
higher costs may result from a prolonged absorption period—e.g., additional market-
ing or carrying costs, tenant improvements, leasing commissions, and administrative
expenses. The increase in costs caused by a market out of balance can contribute to
external obsolescence.
Some indirect costs, such as architectural fees, are generally related to the size
and cost of the project. These are often estimated as a percentage of direct costs.
Other costs, such as leasing and sales commissions, are related to the type of property
or market practice. Still others, such as fees for appraisals and environmental stud-
ies, are a function of the time and complexity required to accomplish the task. The
Table 29.1 Examples of Direct Costs and Indirect Costs

Direct Costs
• Materials, products, and equipment
• Labor used in construction
• Equipment used in construction and depreciation of equipment during construction
• Security during construction
• Contractor’s shack and temporary fencing
• Material storage facilities and transportation costs
• Power line installation and utility costs
• Contractor’s profit and overhead, including job supervision, coordination and management (when appropriate),
worker’s compensation, and fire, liability, and unemployment insurance
• Performance bonds
Indirect Costs
• Building permits
• Architectural and engineering fees for plans, plan checks, surveys to establish building lines and grades, and
environmental studies
• Appraisal, consulting, accounting, and legal fees
• All-risk insurance expense and ad valorem taxes during construction
• The cost of carrying the investment in land and contract payments during construction*
• The cost of carrying the investment in the property after construction is complete but before stabilization is achieved
(if leased fee valuation)
• Supplemental capital investment in tenant improvements and leasing commissions
• Marketing costs, sales commissions, and any applicable holding costs to achieve stabilized occupancy in a normal market
(if leased fee valuation)
• Administrative expenses of the developer
• Local government development levies
* If construction financing is required, the points, fees or service charges, and interest on construction loans are indirect costs.

indirect costs of carrying an investment during and after construction are a combina-
tion of all of the above. Although total indirect costs are sometimes estimated as a
percentage of direct costs, more detailed studies of these costs are often warranted.
When a cost estimating service is used, it is important for appraisers to be able to
identify which costs are already included in the cost estimates and which need to be
added by the user of the cost service.
Entrepreneurial Incentive and Entrepreneurial Profit

Entrepreneurs (developers, contractors, investors, and others) compete against each
other in the real estate marketplace, and any building project will include an eco-
nomic reward (above and beyond direct and indirect costs) sufficient to convince an
entrepreneur to take on the risk associated with that project in that market. For a new
building that is the highest and best use of the site, the difference between the market
value and the total cost of development (i.e., the sum of land value and direct and
indirect costs) is the profit—or loss—realized:
Market Value - Total Cost of Development = Profit (or Loss)
Whether or not a profit is actually realized depends on how well the entrepreneur
has analyzed the market demand for the property, selected the site, and constructed
the improvements. In the case of income-producing properties, the profit realized
will also depend on the entrepreneur’s ability to obtain the proper tenant mix and
negotiate leases in a reasonable amount of time.
The term entrepreneurial incentive refers to the amount an entrepreneur expects
or wants to receive as compensation for providing coordination and expertise and
assuming the risks associated with the development of a project. In contrast, entre-
preneurial profit refers to the difference between the total cost of development and
marketing and the market value of a property after completion and achievement of
stabilized occupancy and income.3 In short, incentive is anticipated while profit is
earned. In most cases, if the entrepreneur sees no potential to make a profit, a new
building will not be built. This profit is as essential to the indication of value in the
application of the cost approach as the costs of building materials and labor.
The concept of entrepreneurial profit is distinct from the broader idea of econom-
ic profit, which is defined as “the difference between sales revenue and the full op-
portunity cost of resources involved in producing goods.”4 In perfectly competitive
and efficient markets, economic profit is effectively zero in the long run because new
firms enter industries that are earning excess profits, which raises the price of scarce
productive resources and lowers the market price of output as the market moves
toward equilibrium where market price equals the sum of the opportunity costs of all
resources used in production. The term entrepreneurial profit or entrepreneurial incen-
tive is used in the application of the cost approach to refer to the realized or expected
component of value for project profit included in a value estimate.
As a market-derived figure, an estimate of entrepreneurial profit or entrepreneur-
ial incentive is only as reliable and precise as the available market data warrants. For
example, for several years following the economic downturn in 2008, a dearth of new
3. Historically, entrepreneurial profit has been the more common term in general usage and serves as a broader term in the discussion of the cost
approach. In this text, the term entrepreneurial incentive, which is a more recent addition to the appraisal lexicon, is used specifically in reference
to a situation that calls for a forecast of the reward an entrepreneur expects to receive at the completion of a real estate development.
4. Paul A. Samuelson and William D. Nordhaus, Economics, 13th ed. (Boston: McGraw-Hill/Irwin, 1989), 980.

construction left appraisers with little current data on development activity, making
estimates of entrepreneurial incentive difficult to forecast. Nevertheless, most market
areas have a typical or appropriate range of expected reward that can be determined
through market research, usually through interviews with developers and other mar-
ket participants about anticipated, acceptable, and actual levels of profit achieved in the
market. The range of profit will vary for different types of structures and with the na-
ture or scale of a given project. The entrepreneurial incentive for a proposed develop-
ment may be higher where creative concepts, greater risk, or unique opportunities have
market acceptance. Less risky, more standard competitive projects may merit a lower
measure of profit. For example, the first speculative high-rise office park in a suburban
market is likely to require greater entrepreneurial incentive than a new residential sub-
division development in a community with demonstrable population growth.
The stage of development, and the different levels of risk and expertise that may be
required at different stages, can affect the amount of entrepreneurial profit earned. For
example, an entrepreneur can start earning a reward from the start of the project. This
reward can increase as land is acquired, plans are drawn up, permits are approved,
financing is secured, contracts are signed, construction is completed, and units are sold
off or leased. It can be difficult to estimate exactly how much entrepreneurial profit
would be earned at each stage of construction, although lenders may require interim
values that reflect financing costs and taxes during the construction and leasing phases.
In practice, separating the value impact of the entrepreneurial coordination from
other market influences can be difficult, particularly during periods of little new con-
struction. To ensure the reasonableness of an estimate of entrepreneurial incentive or
entrepreneurial profit, appraisers should carefully examine the source of additional
property value over and above the total cost of development and the effects of sup-
ply and demand for properties of that type in the subject property’s market area. For
example, some appraisers point out that the value associated with the amenities of
a property may be such that the sale price of the property could significantly exceed
the sum of the costs of the land, building, and marketing (e.g., in an overheated
seller’s market where sale prices are inflated).
Some appraisers also observe that entrepreneurial profit often represents a theo-
retical profit in certain build-to-suit, owner-occupied properties. An owner-occupant
may consider any additional operating profit due to the property’s efficient design to
be an incentive to develop and occupy that property. However, the entrepreneurial
profit might only be realized years after the property is built, when it sells to a similar
owner-occupant at a premium because the property is suitable and immediately
available, unlike new construction or conversion of a different property. In this case,
the entrepreneurial profit realized upon the later sale is likely to become obscured
over time by changing market conditions.
The issue of entrepreneurial incentive is more complex with certain types of
specialized owner-occupied properties. For example, buildings developed and used
by governmental bodies or buildings owned and occupied by religious organizations
are likely not developed with an expectation of realizing an entrepreneurial profit.
In the case of specialized private owner-occupied improvements, entrepreneurial
incentive is as much a part of the construction as the building materials used in the
improvements. However, the reality is that in properties that are constructed for
owner occupancy as opposed to economic returns, the entrepreneurial incentive may

Contributions of the Entrepreneur, Developer, and Contractor
The measure of profit used in the cost approach is the amount required to entice an entrepreneur to take on
the project. In analyzing the components of reward and compensation actually received (or anticipated) by
an entrepreneur, appraisers may choose to further distinguish between the concepts of project profit, entre-
preneurial profit, developer’s profit, and contractor’s profit:
• Project profit is the total amount of reward for entrepreneurial coordination and risk.
• Entrepreneurial profit refers to the portion of project profit attributable to the efforts of the entrepreneur,
distinct from the efforts of the developer, if one is present. In projects in which the entrepreneur and the
developer are the same person, the entrepreneurial profit comprises distinct cost items for the different
roles served by the individual, with the sum of those items equivalent to total project profit.
• Developer’s profit represents compensation for the time, energy, and expertise of an individual other than
the original entrepreneur—usually, in large projects, the person responsible for managing the overall devel-
opment process.
• Contractor’s profit (including subcontractors’ fees) is essentially a portion of the project’s overhead and is
not usually reflected in the entrepreneurial reward.
The measure of project profit used in cost approach calculations usually includes both a developer’s profit
and an entrepreneurial profit. The profit a contractor receives is often already reflected in the fee a contractor
charges and would therefore be included in the direct costs.
be the first cost lost in value if those properties are not constructed similar to the ideal
improvement. An owner-occupant may consider additional operating profit, long-
term control, or ownership pride or prestige to be an adequate incentive to develop
and occupy that property.
The way in which comparable properties have been developed affects the avail-
ability of data. Appraisers are sometimes able to calculate entrepreneurial profit from
actual comparable costs for speculatively built properties such as condominiums and
multifamily developments. In the value estimate of a speculatively built property, en-
trepreneurial profit represents a return to the entrepreneur for the skills employed and
the risks incurred, although the actual return may differ from the anticipated return. In
large-scale developments, however, the issue is complicated because the entrepreneur-
ial profit may not reflect the proportionate contributions of the improved site and the
improvement to the overall property value. Developers of tract subdivisions, for ex-
ample, often realize most of their profit on the value of the houses built on the finished
lots, not necessarily on the value of the lots, which could be analyzed as a separate
investment opportunity with its own separate measure of entrepreneurial profit.
Data on entrepreneurial profit for custom-built properties may not be available
if the property owner who contracted the actual builders was acting as the devel-
oper. The prices of upscale, custom-built properties often reflect the attractiveness
of these amenity-laden properties as well as the high costs of the materials used.
Thus, the breakdown of costs for custom-built properties may not be comparable
to the breakdown for speculatively built properties, which further complicates the
task of estimating a rate of entrepreneurial profit. Theoretically, however, the value
of custom-built properties should also reflect an entrepreneurial profit, although
functional obsolescence may offset that profit when the custom-built improvements
do not serve the market.
Appraisers should also scrutinize the cost data on which the value estimate is
based to determine whether or not an allowance for entrepreneurial incentive or

entrepreneurial profit has already been made. If this is not done, the contribution of
the entrepreneur could be included twice. Data derived from sales of comparable
sites often includes a profit for the land developer. Cost-estimating services quote
direct costs (e.g., contractor’s profit) and indirect costs (e.g., sales costs), but they may
or may not provide estimates of entrepreneurial incentive or entrepreneurial profit.
Because different sources of data reflect costs in different ways, appraisers should
identify where the entrepreneurial incentive or profit is considered in an estimate—
i.e., whether it is an item already included in the sum of total cost and land value or a
stand-alone item added to the sum of total cost and land value.
Depreciation
The market recognizes the occurrence of losses in the value of improvements due to
the effects of age, wear and tear, and other causes, and an appraiser interprets how
the market perceives the collective effect of all forms of depreciation.5 In short, depre-
ciation is the difference between the contributory value of an improvement and its
cost at the time of appraisal:
Cost of Improvement - Contributory Value of Improvement = Depreciation
where the cost of improvement is either reproduction cost or replacement cost. By
estimating the depreciation incurred by an improvement and deducting this estimate
from the improvement’s reproduction or replacement cost, an appraiser can conclude
the depreciated cost of the improvement. This depreciated cost is an indication of the
improvement’s contribution to the property’s market value. (Techniques for estimat-
ing depreciation are discussed in Chapter 31.)
Depreciation in an improvement can result from three major causes operating
separately or in combination:
• Wear and tear from regular use, the impact of the elements, or damage, which is
known as physical deterioration and may be curable or incurable
• A flaw in the structure, materials, or design that diminishes the function, util-
ity, and value of the improvement, which is known as functional obsolescence and
again may be curable or incurable
• A temporary or permanent impairment of the utility or salability of an improve-
ment or property due to negative influences outside the property, which is
known as external obsolescence and is rarely curable
External obsolescence may result from adverse market conditions. Because of its
fixed location, real estate is subject to external influences that usually cannot be con-
trolled by the property owner, landlord, or tenant.
Theoretically, depreciation can begin in the design phase or the moment con-
struction is started, even in a functional building that is the highest and best use of a
site. Improvements are rarely built under ideal circumstances, and their construction
takes considerable time. During the construction process, physical deterioration can
be temporarily halted or even corrected, but physical deterioration tends to persist
throughout the life of the improvements. Moreover, as time goes on and a building’s
features become dated in comparison to new buildings, functional obsolescence sets
in. Consider, for example, an industrial building that was built in the early 1970s. The
5. See Chapter 12 for discussion of the legal concept of "diminution in value," which is distinct from depreciation.

structure’s 18-foot-high ceilings, which were the market standard at the time of con-
struction, might be considered totally inadequate now that greater clear heights are the
norm. New buildings can have functional obsolescence even before they are construct-
ed, which is usually attributable to a design that does not meet market standards.
In the cost approach, the depreciation attributable to all causes is extracted from
the market (or calculated when market extraction is not possible) and deducted from
the current cost to arrive at the depreciated cost:
Current Cost - Total Depreciation Applicable = Depreciated Cost
The depreciated cost of all improvements (or their contribution to value) and the land
value are added together to provide an indication of the market value of the property:
Depreciated Cost + Land Value = Market Value
Depreciation is a penalty only insofar as the market recognizes it as causing a loss in
value. For some older buildings, the value loss due to apparent depreciation may be
offset by a temporary scarcity relative to demand or by an improvement’s historical
Depreciation in Appraising and Accounting

Many of the terms appraisers use are also used in other professions with the same, similar, or different
meanings. The term accrued depreciation, which appeared in earlier editions of The Appraisal of Real Estate,
was originally borrowed from accounting practice. In accounting, accrued depreciation (or alternatively ac-
cruals for depreciation) refers to the total depreciation taken on an asset from the time of purchase to the
present, which is normally deducted from an asset’s account value to derive net book value. While accrued
depreciation was used in an appraisal context for many years in the past, the simpler and more concise term
depreciation is equally suitable and has been used in the most recent editions of the textbook.*
Book depreciation is an accounting term that refers to the amount of capital recapture written off for
an asset on the owner’s books for income tax or financial reporting purposes. Under the current generally
accepted accounting principles (GAAP) in the United States, the term has typically been used in income tax
calculations to identify the amount allowed as accruals for the retirement or replacement of an asset under
the federal tax laws. Book depreciation may also be estimated using a depreciation schedule set by the Inter-
nal Revenue Service. Book depreciation is not market-derived like the depreciation estimates developed by
appraisers. Instead, various formula-based techniques (e.g., the straight-line method, the units of production
method, the declining balance method, the sum-of-the-years’-digits method) have been used to calculate
scheduled depreciation.
The International Financial Reporting Standards treat depreciation in a similar fashion as US GAAP with
two significant distinctions:
1. The estimates of useful life and residual value of the property are reviewed at least at each annual report-
ing date, which can be more frequent than under US GAAP.
2. The available depreciation models include the cost model (similar to US GAAP) and the fair value–based
revaluation model (which allows for the revaluation of property on a company’s books when fair value can
be measured).
International Accounting Standard 16: Property, Plant, and Equipment details the methods of estimating
depreciation for financial reporting purposes.
Financial Accounting Standards Board Accounting Standards Codification Topic 820: Fair Value Measure-
ments and Disclosures (formerly known as SFAS 157) calls for market-supported depreciation that is broader
than depreciation for financial reporting purposes (an allocation of historical cost) or tax purposes (based on
specified service lives).
* The term total depreciation also remains in use by appraisers, although depreciation is used without modification in this textbook in
most cases to refer to estimates of both the total amount of depreciation that a property suffers from or the amount of depreciation
attributable to a particular form of depreciation (i.e., a part of the whole).

or architectural significance. In these situations, an appraiser should exercise caution
not to penalize a property unduly in the cost approach.
As mentioned earlier, an appraiser’s use of reproduction cost rather than replace-
ment cost to derive a current cost estimate will affect the estimation of depreciation.
Some forms of functional obsolescence are eliminated when replacement cost is used,
but other forms remain unaffected. Consider an industrial building with poor access
for trucks and with a 28-foot ceiling height in a market where 24-foot ceiling heights
are the norm. A replacement cost estimate could be based on a building with a 24-
foot ceiling height, while a reproduction cost estimate would be based on a building
with a 28-foot ceiling height. By using replacement cost instead of reproduction cost,
an appraiser eliminates the superadequacy attributable to the story height but not
the deficiency caused by poor access to the street. Moreover, any additional costs of
ownership caused by the superadequacy would not be eliminated in the replacement
cost estimate. If the excess story height were the cause of additional heating, cool-
ing, insurance, or property taxes, the superadequacy would also cause additional
depreciation. An appraiser using replacement cost would have to consider any excess
operating costs associated with the superadequate construction.
Property Rights and Rent-up Adjustments

The value indication developed using the classic cost approach procedure is the value
of the fee simple interest in the property at stabilized occupancy and at market rent
and terms. A property rights adjustment is necessary when property rights other than
fee simple are being valued. For example, property rights adjustments can be made
to account for leased fee or leasehold property that is leased at a below-market rate or
is empty or partially leased. A leased fee or leasehold adjustment would be necessary
when a tenant is paying more or less than market rent and terms. The estimation of a
property rights adjustment generally involves the use of sales comparison or income
capitalization techniques, as discussed in Chapter 21.
Direct comparisons of the price of a leased fee with the price of the fee simple
estate of comparable properties may reveal that the calculation of a property rights
adjustment with income capitalization techniques understates or overstates the actu-
al effect on the value of the leased fee. Real estate markets are not perfectly efficient,
and risk may not always be distributed efficiently to the various legal interests, i.e.,
the value of the whole may not equal the sum of the parts.
Market analysis may indicate a rent-up adjustment may need to be made for
an empty or partially empty building that is not yet at stabilization or has not yet
achieved market rental rates. The lease-up period for a rental property typically re-
quires an investment of time and money, so the market value of the property when it
is empty is likely to be less than the value of the property when it is full. The value of
the lost revenue (i.e., what is known as a shortfall) during a building’s lease-up period
could be discounted at an appropriate rate considering the risk of the shortfall.
Consider a newly developed multitenant office-warehouse with an anticipated
leasing period of two years after completion of construction. Shortfalls in the first
two years after completion of the property are calculated by comparing the antici-
pated net cash flow upon completion with the net operating income as if stabilized
upon completion. For example, suppose that upon completion of construction the
projected partial occupancy of the facility would generate a net cash flow of $250,000

in the first year of operation, but, if the facility were fully leased at that time, then the
property would be expected to generate $600,000 in that same period. In this case, the
shortfall in the first year is $350,000. Various techniques could be used to convert the
shortfalls during the lease-up period into a rent-up adjustment:
1. Discounting the shortfalls at the property yield rate and including a proportion-
ate amount of entrepreneurial incentive for the lease-up period
2. Comparing the discounted present value of the property as if stabilized with the
present value of the property upon completion discounted at a higher rate to
reflect the risk of the lease-up period
3. Discounting the shortfalls at a safe rate (with or without adding entrepreneurial
profit depending on market practice)
4. Summing the tenant improvements, leasing commissions, and income shortfalls
and adding an entrepreneurial incentive
5. Increasing the overall capitalization rate used to calculate the value of the stabi-
lized income stream before deducting cash flow shortfalls to account for the risk
In the application of the cost approach, estimating a rent-up adjustment usually in-
volves discounting the shortfalls at an appropriate rate and including the proportion of
the project’s entrepreneurial incentive that would be expected to be achieved after the
entitlement and construction phases of development (i.e., during the lease-up period).
In some situations, a property can be worth more, or can sell for more, when it is
empty than when it is full. For example, in a market with rapidly rising rents, a build-
ing with empty space may be better able to take advantage of rent appreciation than a
building with long-term leases in place, requiring an upward adjustment for the value
of the leasehold estate. However, volatility in rental rates can be a sign of weakness in
market fundamentals, so market analysis would be important in forecasting demand
for the empty space and the accompanying risk of that space not being rented at all.
In a balanced market, feasibility rent—the rent needed for the property to be
worth its cost—will be the same as market rent. For example, if a property costs $100
per square foot, then the feasibility rent in a market where capitalization rates for
similar properties average 10% would be $10 per square foot. In a poorly perform-
ing market, new construction should not resume until the level of market rent rises
to meet the feasibility rent. Similarly, the feasibility of adding new improvements or
renovating existing improvements can be tested by comparing market rent with the
feasibility rent after adjustments for the additional cost of the proposed changes. For
example, suppose a 50,000-sq.-ft. expansion of an office-warehouse would increase
the replacement cost of the building from the $100 per square foot figure for the origi-
nal building to $105 per square foot for the expanded building. If the capitalization
rate remained 10%, then the market rent would have to increase to $10.50 per square
foot before the expansion would make economic sense.
If contract rent is greater than market rent, a negative leasehold benefit is created.
In that case, the landlord is collecting more rent than would be achievable in the mar-
ket at that time. In contrast, when feasibility rent is greater than current market rent,
no one receives a benefit from that difference.

Building Cost Estimates 30
To apply the cost approach to value, appraisers estimate the cost of the improve-
ments as of the effective date of appraisal. To prepare this sort of estimate, apprais-
ers need to understand construction plans, specifications, materials, and techniques.
They can access a variety of publications, computer software, and accompanying
data available for this purpose, or the work can be done with the assistance of expert
cost estimators. In either case, the appraiser is responsible for the result, and any
existing improvements should be carefully reviewed and described by all individuals
who are delegated to estimate costs. In addition, the appraiser should be sure the cost
method applied is consistent with the property rights being appraised.
Proposed improvements may be valued based on plans and specifications provid-
ed that the appraiser discloses that the improvements have not yet been built. If the
effective date is current, the appraisal would require a hypothetical condition that the
improvements exist as of that date. If the effective date is prospective, it may require
an extraordinary or specific assumption that the improvements will be constructed in
the manner described and by the anticipated date. Appraisers are commonly asked
to provide an opinion of prospective value under the extraordinary assumption or
special assumption that a property will be completed as planned (or completed as
planned and having achieved stabilized occupancy) as of a future date. Appraisers are
also asked to provide a current opinion of value based on the hypothetical condition
that the proposed improvements had already been completed as of the effective date.
When appraisers are asked to value property that has not yet been completed,
two prospective values are sometimes called for:
1. The value at the time of completion
2. The value when stabilized occupancy and income are achieved
The values may be based on the extraordinary assumptions or special assumptions
that the improvements will be completed as proposed on a future date (for the value
upon completion) and that the property will be stabilized (for the value upon reach-
ing stabilization).
Sources of Cost Data
Construction contracts for buildings similar to the building being appraised provide
a primary source of comparable cost data. Some appraisers maintain comprehensive
files of current cost data, including current costs for completed houses, apartments,
hotels, office buildings, retail buildings, and industrial buildings. Another common
source is a developer’s construction budget, which an appraiser obtains when ap-
praising a proposed development for construction financing purposes. These costs can
provide a basis for calculating the cost to construct a proposed building or an equiva-
lent to an existing building. Contract-reporting services may indicate building areas or
a general building description, the low bids, and the contract award. Appraisers can
then obtain any missing information, such as the breakdown of office and warehouse
space in an industrial property, and classify the building type for filing purposes.
When cost comparable files are carefully developed and managed, they can supply
authentic square-foot costs on buildings of all types for use in appraisal assignments.
In the absence of construction contract data, local building contractors and
professional cost estimators can be reliable sources of data. These sources can of-
ten be found online. In an active market, cost information can also be obtained
by interviewing local property owners who have recently added building or land
improvements similar to those found on the subject property. If work contracts and
accounting records of recently improved properties are available, they can provide
significant details.
Cost-Estimating Services
Many cost-estimating services publish data for estimating the current cost of im-
provements. The most recognized services in the United States include the following:
• Marshall & Swift/CoreLogic (www.corelogic.com/solutions/marshall-swift.aspx)
• Dodge Data & Analytics (http://construction.com/dodge/)
• RSMeans Cost Data (www.rsmeans.com)
Data provided by cost-estimating services can be used independently as a basis for
cost estimation or to confirm estimates developed from local cost data.
Published cost manuals usually include benchmarks for direct unit costs but
rarely include benchmarks for indirect costs—such as escrow fees, legal fees, interest
on construction loans, financing fees, carrying charges, and property taxes—because
these are site specific. For example, cost manuals do not include the costs of construc-
tion loan points and permanent loan fees, so appraisers often research ranges of rates
through discussion with lenders of the respective types of loans. Appraisers should
recognize what indirect costs are included and excluded in published cost estimates.
Appraisers research their markets to determine which costs are most applicable
to specific appraisal assignments. National cost services generally list the benchmark
cost of many site improvements separately, rather than as part of building costs. This
data includes the costs of roads, storm drains, rough grading, soil compaction, utili-
ties, and jurisdictional utility hookup fees and assessments. Demolition costs may be
included in published cost services and they also can be obtained from actual costs
or demolition contractors. Also, entrepreneurial incentive or entrepreneurial profit is
generally not included in cost service data. Appraisers usually estimate those costs
separately and then include them in the estimate of total cost.

Although buildings can be
measured in several ways, appraisers Common Construction-Related Costs
should measure buildings according Typically Not Included in Cost Manuals
to local custom. For cost purposes, • Cost of land acquisition and assemblage
appraisers should measure them con- • Trade fixtures
sistently with the way the cost data • Personal property
is developed. However, appraisers • Specialized equipment
must understand the measurement • Permanent financing fees
technique used by the cost service • Marketing costs, leasing commissions, rent con-
cessions, fill-up costs
in order to use that service’s data
• Real estate taxes
effectively. Several cost-estimating
• Entrepreneurial incentive and developer’s over-
services publish manuals or maintain head and profit
electronic databases that break down
costs into square foot increments.
Unit costs for building types usually
start with a building of a certain size (i.e., a base area), which serves as a benchmark.
Then additions or deductions are made to account for the actual area in square feet
and the building components in the subject property.
Cost Index Trending

Cost manuals and electronic databases periodically update the cost index tables that
reflect changes in the cost of construction over a period of years. Cost indexes can be
used to convert a known cost as of a past date into a current cost estimate. Sometimes
cost index tables can be used to adjust costs for different geographic areas. Cost index
trending is also useful for estimating the current cost of one-of-a-kind items when
standard costs are not available. However, there are practical limitations in applying
this procedure because the reliability of the current cost indication tends to decrease
as the time span increases.
As an example of cost index trending, suppose the contract cost for constructing
a building in January 2016 was $1 million. Suppose the index for January 2016 was
285.1 and the current index is 327.3. To trend the historical cost into a current cost,
the current cost index is divided by the historical cost index and the resulting ratio is
multiplied by the historical cost. In this case the current cost is calculated as follows:
327.3
285.1 = 1.14
1.14 × $1,000,000 = $1,148,000
Problems may arise when cost index data is used to estimate current cost. The
accuracy of the figures cannot always be determined, especially when it is not clear
which components are included in the data (e.g., only direct costs or direct costs with
some indirect costs). Furthermore, historical costs may not be typical for the time
period, and the construction methods used and building codes in effect at the time of
the historical cost may differ from those applicable on the effective appraisal date.
Cost-Estimating Methods
The three traditional cost-estimating methods are
• The comparative-unit method (or calculator method)

• The unit-in-place method (or segregated cost method)
• The quantity survey method
The quantity survey method produces a cost estimate based on a detailed inven-
tory of the labor, materials, and equipment used in the subject improvements. The
Estimating Entrepreneurial Incentive

Entrepreneurial incentive is a cost that is as real as the cost for any building material because no develop-
ment project would be undertaken without the prospect of an economic reward. The cost of entrepreneurial
incentive should always be included in any estimate of building cost, but that potential economic reward will
be the first loss to the entrepreneur if the project is not successful.
Regardless of the cost-estimating method applied, estimates of entrepreneurial incentive should be de-
rived through market analysis and interviews with developers to determine the expectations of entrepreneur-
ial reward required as motivation to undertake a particular development. Questions often asked of developers
include the following:
• What percentage amount of profit was expected?
• If profit is expressed as a percentage, is it a percentage of (a) direct costs, (b) direct and indirect costs, or
(c) direct and indirect costs plus site value?
• What is included in the percentage?
• Did the project meet expectations?
• Would you do another project for the same percentage of profit?
The actual entrepreneurial profit earned is a record of results and can differ from the anticipated profit (i.e.,
the incentive) that originally motivated the entrepreneur to proceed. A typical level of anticipation or incentive
should be used in the cost estimate.
Depending on market practice, entrepreneurial incentive or entrepreneurial profit may be estimated in
different ways:
• As a percentage of direct costs
• As a percentage of direct and indirect costs
• As a percentage of total current development cost, i.e., direct and indirect costs plus site value
In some markets, entrepreneurs may have a threshold amount that would induce them to take on a develop-
ment project, and the appropriate amount of incentive could be a flat fee in that case rather than a percent-
age of a certain combination of development costs.
Presumably, the dollar amount of entrepreneurial incentive would be the same regardless of how it is cal-
culated—e.g., as 22%, 20%, or 15% of the appropriate base cost selected, as shown below. In the following
example, an appraiser investigated the dollar amount of certain costs and ratios (or relative percentages) of
entrepreneurial incentive attributable to the same set of costs and then calculated entrepreneurial incentive:
Entrepreneurial
Base Cost % Applied Incentive
Direct Costs 22.0% × $545,000 = $120,000
(rounded)
Direct Costs + Indirect Costs 20.0% × ($545,000 + $55,000) = $120,000
Direct Costs + Indirect Costs + Land Value 15.0% × ($545,000 + $55,000 + $200,000) = $120,000
Estimating an appropriate amount of entrepreneurial incentive remains a challenge for appraisers because
expectations of profit vary with different market conditions and property types. Consistent relationships
between profit and other costs are difficult to establish and sources are difficult to find. Other profession-
als may define profit differently than appraisers do and not every project is anticipated to be profitable. A
company may need a new building for the business even though the cost of the building may be greater than
its market value. This is a business decision, not a real estate investment decision. If entrepreneurial incentive
is added, the loss would be considered in increased obsolescence.

comparative-unit and the unit-in-place methods provide less detail, but they are the
primary bases for the cost estimates used in most appraisals.
Many appraisers apply the comparative-unit method using data from a cost-
estimating service. The unit-in-place method and the quantity survey method require
more data, and their applicability is limited when abundant construction cost data is
not available. Cost-estimating services offer an efficient way to produce reasonably
accurate and detailed cost calculations when the subject property is similar to the
prototypes described in the manual.
Comparative-Unit Method
The comparative-unit method is used to derive a cost estimate measured in dollars
(or some other currency) per unit of area. The method employs the known costs of
similar structures adjusted for market conditions and physical differences. Indirect
costs may be included in the unit cost or computed separately. If the comparable
properties and the subject property are in different markets, an appraiser may need
to make an adjustment for location.
Unit costs vary with size. All else being equal, unit costs decrease as building
areas increase. This reflects the fact that plumbing, heating units, elevators, doors,
windows, and similar building components do not usually cost proportionately more
in a larger building than in a smaller one and that other efficiencies and economies of
scale may be realized.
The comparative-unit method is relatively simple and practical, and it is widely
used. Unit cost figures are usually expressed in terms of gross building dimensions
converted into square or cubic feet (or meters where appropriate). Total cost is estimated
by comparing the subject building with similar, recently constructed buildings for which
contract prices are available. The trend in costs between the date of the contract (or con-
struction) and the effective appraisal date should be factored into the comparison.
Most appraisers using the comparative-unit method apply unit cost figures de-
veloped from a recognized cost service. Unit costs for the benchmark buildings found
in cost-estimating manuals usually start with a base building of a specified size. Ad-
justments or refinements are then made to the base cost for any differences between
the subject building and the benchmark building. If the subject building is larger
than the benchmark building, the unit cost is usually lower. If the subject building
is smaller, its unit cost will probably be higher. The cost data obtained from a recog-
nized cost service is usually the replacement cost new, which reflects current building
standards and materials. It is not an indication of reproduction cost new.
Because few buildings are identical in terms of size, design, and quality of con-
struction, the benchmark building is often different from the subject building. Differ-
ent roof designs, interior design characteristics, and irregular perimeters and build-
ing shapes can affect comparative-unit costs substantially. Figure 30.1 illustrates this
situation. For example, the larger perimeter of Building B in the illustration results in
higher unit costs. Most cost services include adjustment criteria to alter or adjust the
base cost to the specific characteristics of the subject structure. However, all elements
may not be addressed by the cost service, and a more “building-specific” cost analy-
sis developed using the unit-in-place method may be needed.
To develop a reliable estimate with the comparative-unit method, an appraiser
first identifies the construction class and type of structure, and then calculates the

Figure 30.1 Unit Costs of Buildings with Different Shapes
Building A Building B
P = 100 + 100 + 100 + 100 P = 50 + 200 + 50 + 200
= 400 feet = 500 feet
50 ft.
100 ft.
A = 10,000 sq. ft.

100 ft.
100 ft.
Area:Perimeter = 25:1
A = 10,000 sq. ft.

200 ft.
200 ft.
Area:Perimeter = 20:1
100 ft.
Cost of Walls
Building A Building B
Unit cost $100 $100 per linear foot
Perimeter × 400 × 500 feet
Total cost $40,000 $50,000
Area 10,000 10,000 square feet
Unit cost $4.00 $5.00 per square foot
50 ft.
unit cost from similar improvements or adjusts the unit cost figure to reflect varia-
tions in size, shape, finish, and other characteristics. For example, the building classes
for warehouse structures in the Marshall & Swift-CoreLogic cost manual are
• A
• B
• C

• D
• S
Each of those classes refers to a particular type of basic construction (e.g., C corresponds
to concrete masonry block with metal or wood roof structure and S to pre-engineered
metal frame and roof structure), and the type of construction ranges from low-cost to ex-
cellent. In addition, the unit cost applied in the comparative-unit method should reflect
any changes in cost levels between the date of the benchmark unit cost and the effec-
tive appraisal date. The ratio between the costs of mechanical equipment and the basic
building shell has increased consistently through the years. Equipment tends to in-
crease unit building costs and depreciate more rapidly than other building components.
To use area cost estimates, an appraiser assembles, catalogs, and analyzes data on
actual building costs. These costs should be divided into general construction categories,
and separate figures should be used to account for special finishes or equipment. The
overall area unit cost can then be broken down into its components, which may help an
appraiser adjust a known cost for the presence or absence of items in later comparisons.
The apparent simplicity of the comparative-unit method can be misleading. To
develop dependable unit cost figures, appraisers must exercise judgment and care-
fully compare the subject building with similar or standard structures for which ac-
tual costs are known. It is important for the appraiser to make decisions about basic
construction and quality based on the cost service descriptions rather than making a
determination independent of these descriptions. Otherwise, the cost numbers will
not be reliable. When it is correctly applied, however, the method produces credible
estimates of cost.
The warehouse shown in Figure 30.2 will be used to illustrate the comparative-
unit method (and later the unit-in-place and quantity survey methods). For the
purpose of this example, the warehouse is of average-quality Class C construction, as
defined in the Marshall & Swift-CoreLogic cost manual.
Table 30.1 shows how comparative-unit costs from a published cost manual can
be applied to the warehouse building. Calculations such as those shown can be used
to confirm a cost indication obtained from construction contracts for similar properties
in the same market as the property being appraised on or near the effective appraisal
date. Published data can be used independently when no local cost data is available.
In Table 30.1 an adjustment for the warehouse’s sprinkler system was made using
a square-foot unit cost. An appraiser should note whether it is a wet or dry system. In
other cases, similar adjustments may be appropriate for observed physical differences
in the amount of office area, construction features, or specific HVAC equipment.
Cost manuals rarely include all indirect costs or an allowance for entrepreneurial
incentive or profit, so adjustments must often be made to obtain an indication of the
total cost. In Table 30.1 adjustments are made for
• Indirect costs not included in the base price quoted in the cost manual
• Indirect costs after construction needed to achieve typical stabilized occupancy1
• Entrepreneurial incentive calculated as a percentage of total direct and indirect costs
1. The cost to achieve stabilized occupancy may be nominal for a single-tenant building or a typical owner-occupied building. However, large multiten-
ant warehouse, office, or apartment properties can have substantial lease-up costs, promotional expenses, or other costs (or losses in income)
that must be considered.

Figure 30.2 Plan of a Warehouse
Basic Construction
Building structure: Reinforced concrete spread footings and 12-inch stem wall; 6-inch steel framing w/
6-inch pipe columns 50-foot o.c.; 8-inch masonry block exterior walls; painted exterior finish.
Roof structure: Steel bar joists w/ insulated metal roof deck with single-ply EPDM 20-year roof covering.
Electrical: Average and typical.
Site improvements: 80% asphalt paving and balance landscaping.
Warehouse Area
Floor: 6-inch reinforced concrete
slab on grade, sealed and 110 ft.
Office
insulated.
HVAC: Suspended gas-fired unit
heaters.
Lighting: Attached LED
Doors: Four 14-foot metal 40 ft.
overhead doors; four steel
280 ft.
250 ft.
man doors.
Truck Truck
Docks Lane
240 ft.
412.09 ft.
Office Area
Office finish: 300 linear feet painted drywall; suspended acoustical grid w/ recessed fluorescent lighting; two
three-fixture ADA restrooms; commercial-grade glue-down carpet floor covering; aluminum storefront
w/ insulated glazing; four natural gas heat and electric forced-air rooftop unit HVAC.
The estimated land value was derived through sales comparison. The unit cost of the
site improvements (i.e., landscaping and paving) shown in Table 30.1 was derived
from a cost manual and adjusted for current and local cost multipliers, and the direct
costs of the landscaping and paving were included with the direct costs of the build-
ing improvements in this example to account for indirect costs and entrepreneurial
incentive attributable to all improvements.

Table 30.1 indicates the cost of the warehouse building plus the land value, but
the result shown is more likely to represent the value of a close substitute than a
duplicate structure. Cost services use typical buildings for their base cost, so an ap-
praiser can apply the comparative-unit method, develop reliable adjustment amounts
and factors, and produce a credible property value estimate.
Construction contracts normally include other improvements to the land, such
as parking, driveways, water retention basins, underground drainage facilities, rail
sidings, fences, and landscaping. The possible combinations and varied value contri-
butions of these improvements can cause a wide divergence in unit cost if the total
contract is related to the size of the major improvement only. Therefore, when actual
contract costs from the local market are used in the comparative-unit method, it is
imperative that the costs of these other improvements be excluded from the determi-
nation of the base price so that these costs are not counted twice (first implicitly in the
base unit cost and then again explicitly as an adjustment based on actual costs).
Table 30.1 Comparative-Unit Method (Calculator Method)

Base cost per sq. ft. 60,000 sq. ft. @ $44.89 per sq. ft.
Add for sprinkler system per sq. ft. $2.10 per sq. ft.
Subtotal $46.99 per sq. ft.
Adjustment for building height × 1.086
Adjustment for area/perimeter × 0.839
Current cost multiplier × 1.03
Local cost multiplier × 1.10
Total building cost per sq. ft. $48.51 per sq. ft.
Total direct costs for building 60,000 sq. ft. @ $48.51 per sq. ft. $2,910,572
Landscaping/paving costs 55,385 sq. ft. @ $3.50 per sq. ft. $193,848
Total direct costs for building and site improvements $3,104,420
Indirect costs not included in cost manual* × 1.08
Subtotal $3,352,774
Indirect costs from completion to stabilized occupancy* × 1.05
Subtotal $3,520,412
Entrepreneurial incentive at 10% of total direct and indirect costs × 1.10
Total cost for warehouse building and site improvements $3,872,454
Land value 115,385 sq. ft. @ $3.25 per sq. ft. + 375,001
Total development cost new $4,247,455
* Note: Contractor’s overhead and profit and some other indirect costs are included in these base costs and adjustments. The source of published
cost data should be studied for a complete understanding of what is included in quoted costs. For purposes of simplicity, a percentage was applied
to account for indirect costs.
Unit-in-Place Method
In the unit-in-place method (also known as the segregated cost method), individual unit
costs for various building components are applied to the various subcomponents in
the structure or to linear, area, volume, or other appropriate measures of these compo-

nents. Using this method, appraisers compute a unit cost based on the actual quantity
of materials used and the labor of assembly required for each unit of area. For exam-
ple, the cost can be applied based on the square feet of floor area or linear feet of wall
of a certain height. The same procedure is applied for other structural components.
Unit-in-place cost estimates are made using specific cost data for standardized
structural components as installed, such as the following:
Structural Component Unit
Excavation Cost per cubic yard
Foundation Cost per linear foot of foundation or cubic yard of concrete
Floor construction Cost per square foot
Interior partitions Cost per linear foot
Roofing Cost per square foot (e.g., 100 square feet of roof area)
The unit-in-place concept is not limited to cubic, linear, or area units. The measure
on which the cost is based may be the measure employed in a particular trade, such
as the cost per ton of air-conditioning. The unit-in-place concept may also be applied
to the cost of complete, installed components such as the cost of a roof truss that is
fabricated off site, delivered, and erected.
All unit costs are totaled to provide the estimated direct cost of the entire im-
provement. Unit-in-place cost estimates may be based on an appraiser’s compiled
data, but they are usually obtained from a cost-estimating service that provides up-
dated monthly figures. Contractor’s overhead and profit may be included in the unit
cost figures provided by some cost services, or they may be accounted for separately.
Entrepreneurial incentive is not included. It is a separate added amount that is
estimated by the appraiser independently of the cost manual. Appraisers must know
exactly what is included in any unit price quoted and the cost manual will indicate
what is included. The appraiser should follow the directions given and not make
judgments independent of those directions. Indirect costs are usually accounted for
separately. For example, leasing and marketing costs are typically not included in
cost service data, so appraisers often consult leasing agents as a source of information
for estimates of leasing commissions on a new project. The objective of the unit-in-
place procedure is to count all appropriate costs and avoid any double-counting.
The following example shows how the cost of a brick veneer wall would be cal-
culated on a unit-in-place basis. Costs such as these vary with market conditions and
location. The figures shown are used only for purposes of illustration.
Description Cost Unit
4-in. face brick, installed: common bond, ½-in. struck joints, mortar,
scaffolding, and cleaning included $460.00 per 1,000 bricks
Dimension lumber, erected: 2-in.-x-4-in. wood stud framing,
16 inches on center $360.00 per 1,000 bd. ft.
Sheathing, installed: impregnated 4 ft. x 8 ft., ½-in. $0.42 per sq. ft.
Insulation, installed: 2½-in., foil backing on one side $0.22 per sq. ft.
Gypsum board: ½-in. with finished joints $0.30 per sq. ft.
Paint: primer and one coat flat $0.25 per sq. ft.
From this data the cost per square foot of wall can be estimated as follows:

Description Cost Unit
Bricks $3.45 per 71⁄2*
Wood stud framing $0.24 per 2⁄3 bd. ft.*
Sheathing $0.42 per sq. ft.
Insulation $0.22 per sq. ft.
½-in. gypsum board $0.30 per sq. ft.
Paint + $0.25 per sq. ft.
Total for finished wall $4.88 per sq. ft.
* To calculate a total unit cost, the unit cost of certain construction elements must be converted to the unit measure of the total cost.
In this example, each square foot of wall requires 71⁄2 bricks and 2⁄3 board feet of wood stud framing.
After calculating the unit cost of $4.88 per square foot, an appraiser can esti-
mate the total cost of a veneer wall that meets these standards without detailing the
quantities of material and labor. In practice, a cost analyst would refine the procedure
by adjusting for waste and extra framing for windows and doors, which require wall
openings, lintels, and facing corners.
The unit costs for all components can be calculated in a similar fashion. Once
these are established, an appraiser can estimate the cost of an entire building. When
fully developed, the unit-in-place method provides a substitute for a complete
quantity survey and produces an accurate cost estimate with considerably less effort.
Table 30.2 illustrates how the unit-in-place method can be used to estimate the repro-
duction cost of the warehouse shown in Figure 30.2.
In Table 30.2, adjustments are made for the following:
• Indirect costs not included in the cost manual’s base price
• Indirect costs after construction needed to achieve typical stabilized occupancy
(when the appraisal is of a leased fee)
• Entrepreneurial incentive calculated as a percentage of total direct and indirect costs
Note the difference in total adjustments for indirect costs in Tables 30.1 and 30.2. As
the cost of the property is broken down into more precise increments using the unit-
in-place method, a smaller portion of the total indirect costs is included in the base
price quoted in the cost manual for each building component. The single figure of
cost per square foot that is used in the comparative-unit method typically accounts
for more of the total indirect costs than the individual cost figures for excavation,
site, foundation, framing, and so on. Therefore, the adjustment for “indirect costs not
included in cost manual” in the comparative-unit method may be smaller than the
same adjustment in the unit-in-place method.
In the unit-in-place method, the value of site improvements may be estimated
separately on a depreciated-cost basis and added to the depreciated cost of the
improvements, or the cost of site improvements can be included as a direct cost as
shown in Table 30.2 and thereby be adjusted for entrepreneurial incentive like the
other construction costs. The unit-in-place method is useful to contractors preparing
construction estimates, but most appraisers would use the comparative-unit method
with cost estimates from a cost manual.

Table 30.2 Unit-in-Place Method
$ per Unit
Excavation: building 60,000 sq. ft. 0.42 $25,200
Excavation: site 115,385 sq. ft. 0.34 $39,231
Foundation 940 linear ft. 36.25 $34,075
CMU wall: base 13,160 sq. ft. 22.80 $300,048*
2% per foot over 14-foot base 0.08 – $24,004†
Floor (concrete) 60,000 sq. ft. 4.01 $240,600
Floor (asphalt tile) 4,400 sq. ft. 2.24 $9,856
Ceiling (acoustical tile) 4,400 sq. ft. 7.40 $32,560
Ceiling (suspended grid) 4,400 sq. ft. 1.47 $6,468
Roof joists and deck 60,000 sq. ft. 12.10 $726,000
Roof cover and insulation 60,000 sq. ft. 3.53 $211,800
Plumbing (three-piece restrooms)
Fixtures 9 fixtures 3,450 $31,050
Drains 6 units 605 $3,630
Sprinkler systems 60,000 sq. ft. 2.16 $129,600
HVAC
Warehouse 55,600 sq. ft. 1.56 $86,736
Office 4,400 sq. ft. 6.70 $29,480
Electrical and lighting
Warehouse 55,600 sq. ft. 4.82 $267,992
Office 4,400 sq. ft. 11.10 $48,840
Interior partitions
Walls 4,400 sq. ft. 3.89 $17,116
Doors 10 doors 103.00 $1,030
Overhead doors (4 10 × 14-ft. doors) 560 sq. ft. 35.71 $19,998
Landscaping and paving 55,385 sq. ft. $3.50 $193,848
Miscellaneous specified items $50,000
Subtotal $2,529,162
Current cost multiplier × 1.03
Subtotal $2,605,037
Local cost multiplier × 1.10
Subtotal $2,865,541
Architectural and engineering fees at 5% of direct costs × 1.05
Total direct costs $3,008,818
Indirect costs not included in cost manual‡ × 1.12
Subtotal $3,369,876
Indirect costs from completion to stabilized occupancy
(when the appraisal is of a leased fee)‡ × 1.05
Subtotal $3,538,369
Entrepreneurial incentive at 10% of total direct and indirect costs × 1.10
Total cost of building and site improvements $3,892,206
Land value 115,385 sq. ft. $3.25 + $375,001
* Calculated as Perimeter × Base Wall Height (14 feet) × Unit Cost (per sq. ft.)
† Calculated as Base Cost of CMU Wall × (2% × (Wall Height - 14 feet))
‡ Note: Contractor’s overhead and profit and some indirect costs are included in the base costs. Architect’s fees and other indirect costs are not. The
source of published cost data should be studied for a complete understanding of what is included in the quoted costs. For purposes of simplicity,
a percentage was applied to account for indirect costs.

Quantity Survey Method
The most comprehensive and accurate method of cost estimating is the quantity sur-
vey method, which is more often applied by contractors or professional cost estima-
tors than appraisers. A quantity survey reflects the quantity and quality of all materi-
als used in the construction of an improvement and all categories of labor required.
Unit costs are applied to these figures to arrive at a total cost estimate for materials
and labor. Then the contractor adds a margin for contingencies, overhead, and profit.
Depending on the size of the project and the resources of the contractor, the
quantity survey and cost calculations may be prepared by a single cost estimator or
by a number of subcontractors, whose bids are compiled by a general contractor and
submitted as the final cost estimate. In either case, the analysis details the quantity,
quality, and cost of all materials furnished by the general contractor or subcontractor
and the appropriate cost allowances.
A general contractor’s cost breakdown for the warehouse shown in Figure 30.2 is
summarized in Table 30.3. This is only a summary. The specific quantities and costs
are not indicated.
Contractor bids do not usually include indirect costs or entrepreneurial incentive
or profit. The analysis illustrated in Table 30.3 reflects indirect costs and the calculation
of entrepreneurial incentive as a percentage of total direct and indirect costs. In the ex-
amples presented, indirect costs are considered in various stages of the cost-estimating
procedure. A breakdown of the costs that make up these estimates is preferred to the
percentage adjustment, and an appraiser should provide a breakdown to support the
percentages applied. Note that when the direct costs of the individual elements of con-
struction are broken down into discrete amounts, as shown in Table 30.3, less of the total
indirect costs is accounted for in those cost figures than in the figures for other cost-esti-
mating methods. Thus, the percentage adjustment for total indirect costs is higher.
Site improvements such as parking facilities, landscaping, and signage are com-
monly included in a general contractor’s bid and should be included in a cost estimate
of all improvements. In this case, landscaping and paving are included among the
direct costs so that the adjustment for entrepreneurial incentive accounts for those im-
provements. In a cost estimate of an existing building, a separate itemization of site im-
provements facilitates the consideration of depreciation. Because the quantity survey
method usually produces a cost estimate of a duplicate building, Table 30.3 indicates
the reproduction cost of the warehouse building as of the effective appraisal date.
To produce a quantity survey estimate, each contractor and subcontractor must
provide a breakdown of materials, labor, overhead, and profit. The contractor’s profit
may depend on the volume of work that the contractor has lined up.
Although the quantity survey method produces a complete cost analysis of the
improvements being appraised, it is time-consuming as well as costly and frequently
requires the services of an experienced cost estimator. For these reasons this method
is seldom used in routine appraisal assignments and is typically used only by profes-
sional cost estimators.
The use of a single cost-estimating technique, such as the comparative-unit
method, may not be as effective as the use of multiple methods. In practice, some
appraisers cross check a cost estimate derived from a cost manual using other cost-
estimating techniques. The following example illustrates the application of multiple
cost-estimating techniques.

Table 30.3 Warehouse Property—Contractor’s Breakdown (Quantity Survey Method)
General conditions of contract $10,000
Excavating and grading $75,000
Concrete foundation/footings $35,000
Concrete floor/slab on grade $60,000
Carpentry (includes OHD and pedestrian doors) $250,000
CMU walls $165,000
Structural steel $140,000
Joist, deck, and deck insulation $725,000
Roofing $200,000
Insulation $12,250
Sash $10,000
Glazing $25,000
Painting $40,000
Acoustical material $7,500
Flooring $10,000
Electric $300,000
HVAC $115,000
Piping $40,000
Plumbing and sprinkler system $125,000
Landscaping/paving $195,000
Subtotal $2,539,750
Contingencies 2.5% $63,494
Contractor’s overhead and profit 8% $203,180
Total contract costs $2,806,424
Architectural and engineering fees 5% $140,321
Total direct costs $2,946,745
Indirect costs before, during, and after construction* 20% $589,349
Subtotal $3,536,094
Entrepreneurial incentive 10% $353,609
Total cost of building and site improvements $3,889,703
Land value 115,385 @ $3.25 $375,001
*For purposes of simplicity, a percentage was applied to account for indirect costs.
Consider a small warehouse building located in a five-year-old industrial park.

The building is standard in design and construction and contains 20,000 square feet.
It has 15% office space and two loading doors. There is no obsolescence. An attorney
asks an appraiser to develop a cost estimate that will “hold up in court.”
The appraiser obtains the following information:
• A new 24,000-sq.-ft. warehouse located in the new section of the park was sold
for $1,750,000 last month. It is similar to the subject property and has 3,000
square feet of office area and three loading doors. The site value is estimated to
be $350,000, the cost of a loading door is $5,000, and the site improvements con-
tribute $6,000.

• A local building contractor was interviewed by the appraiser. The contractor
built a 21,000-sq.-ft. structure similar to the subject last year at a total cost of
$1,155,000. The contractor also stated that a 20,000-sq.-ft. warehouse with 3,000
square feet of office space and three loading doors would cost $60 per square foot
to build today.
• The national cost service indicated a base cost of $46.10 per square foot as of two
years ago. The required adjustments are 10% for changing market conditions and
12% for location.
The appraiser makes the following calculations using various cost-estimating techniques:
Cost from Sale
Sale price $1,750,000
Site value (350,000)
Site improvements (6,000)
Loading door (5,000)
Cost of building $1,389,000/24,000 sq. ft. = $57.87
Cost from Contractor
The adjustment for one loading door is $0.25 per square foot.
$5,000/20,000 sq. ft. = $0.25 per sq. ft.
$60.00 per sq. ft. - $0.25 = $59.75 per sq. ft.
Information from Cost Manual
$46.10 × 1.10 × 1.12 = $56.79
The recent sale supports a current cost estimate for the subject building of $57.87
per square foot. Information from the contractor indicates a cost of $59.75 per square
foot. The cost service indicates a cost of $56.79 square foot. The appraiser can rec-
oncile the results of these three cost-estimating techniques to arrive at a final cost
estimate for the subject warehouse.

Depreciation Estimates 31
Appraisers have several methods available for estimating depreciation. Each is ac-
ceptable and should result in roughly the same value as long as appraisers apply
the methods consistently and logically. The methods used in a particular appraisal
assignment should reflect how an informed and prudent buyer would react to the
condition and quality of the property and the market in which the property is found.
The primary goals in the analysis of depreciation are to identify all forms of
depreciation recognized by the market, to treat all these forms of depreciation, and to
charge only once for each form of depreciation (i.e., to avoid double-counting items
of depreciation).1 The three principal methods for estimating depreciation are
• The market extraction method
• The economic age-life method
• The breakdown method
The various methods may be combined to solve specific problems, or each method
may be applied separately to test the reasonableness of the estimates derived from
other methods.
Many appraisers use market extraction and economic age-life calculations as
the primary methods of estimating the total depreciation in a property. The market
extraction and economic age-life methods are applied to the whole property, making
them simpler for appraisers to apply and easier for clients to understand. These meth-
ods are also easier for appraisers to use than the breakdown method even though
the elements of depreciation are implicit, not explicit. Both market extraction and the
economic age-life method are best when the subject and the sales used for extraction
are most similar because the results are a lump sum of depreciation from all sources.
If the subject and sales have different external or functional issues, the results will
reflect different characteristics.
1. Additional discussion of the estimation of depreciation and numerous examples can be found in In Defense of the Cost Approach: A Journey into
Commercial Depreciation (Chicago: Appraisal Institute, 2011).
The breakdown method is a more comprehensive method that identifies spe-
cific elements of depreciation and treats each element separately. It enumerates the
components of total depreciation—physical deterioration, functional obsolescence,
and external obsolescence—and separates physical deterioration into three catego-
ries—deferred maintenance, short-lived components, and long-lived components. If
estimates of total depreciation are available using the economic age-life method or
the market extraction method, the result of the breakdown method can be checked
against those other estimates.
Regardless of the methods applied, appraisers must ensure that the final estimate
of depreciation reflects the loss in value from all causes and that no form of deprecia-
tion has been considered more than once. Double charges for depreciation can pro-
duce inappropriately low value indications in the cost approach. Also, the analysis of
depreciation must be internally consistent, using either reproduction cost or replace-
ment cost as the cost basis throughout. As explained in Chapter 29, the use of replace-
ment cost eliminates the need to consider certain forms of obsolescence. Switching
between reproduction cost and replacement cost within the analysis of depreciation
greatly increases the chances of double-counting items of depreciation.
Age and Life Relationships

All three methods of estimating depreciation consider age-life relationships ei-
ther directly or indirectly. The age and life relationships relate not only to an entire
structure but also to its various components. Depreciation occurs over the life of an
improvement or in a single component of the whole. In theory, an improvement or
component loses all of its value over the course of its life. For example, suppose that
the typical life expectancy of a freestanding retail store in a given market is 40 years.
Theoretically, when the building is 40 years old, it will have reached the end of its life
expectancy and will have lost all of its value to depreciation, with no contributory
value remaining to add to the value of the vacant site. Short-lived building com-
ponents may go through this cycle several times over the same 40-year period. For
example, the life expectancy of a water heater installed in a building will be much
shorter than 40 years, say, 10 years. Some components may have to be replaced sev-
eral times over the building’s 40-year life.
In estimating the total depreciation of an improvement, the concepts most impor-
tant to market extraction are
• Actual age
• Total depreciation
• Annual rate of depreciation
• The implied total economic life that can be estimated (if no functional or external
obsolescence is present)
In the economic age-life method, the most important concepts are
• Total economic life
• Effective age
• Remaining economic life

In applying the concepts of economic life, effective age, and remaining economic
life expectancy, appraisers consider all elements of depreciation in one calculation.
Therefore, the effective age estimate includes not only physical wear and tear but also
any loss in value for functional and external considerations. This type of analysis is
characteristic of the market extraction and economic age-life depreciation methods.
However, the economic age-life method can be modified to reflect the presence of any
known items of curable physical deterioration or incurable deterioration in short-
lived building components.
Curable or Incurable?
The test of curability is a straightforward comparison:
• Items of physical deterioration or functional obsolescence are economically feasible to cure if the cost to
cure is equal to or less than the anticipated increase in the value of the property.
• If the cost to cure is more than the anticipated increase in value, the item is incurable.
For example, if a warehouse with a poorly operating heating and air-conditioning system would require $250,000
in repairs but the increase in value after making those repairs would only be $150,000 because of a relative
surplus of existing warehouse space in the market, then the deficiency is currently incurable. If in six months the
demand for warehouse properties changes because a major new manufacturing facility will open in the market
area, then the potential rent levels for existing warehouse space might rise and the increase in value might
exceed the cost to cure the deficiency. In that case, the changing market conditions would make the deficiency
curable at the later date. A marketability study can help support a forecast identifying when value will rise to
the point where an item of depreciation becomes curable.
In the application of the market extraction method, the actual age is preferred,
and it is important to extract life estimates from comparable properties that have the
same physical, functional, and external characteristics as the subject property. Typi-
cally the market extraction method is not modified to reflect depreciation of short-
lived building components. However, a lump-sum adjustment may be made if the
subject property has curable depreciation in the form of deferred maintenance.
In estimating physical deterioration in the breakdown method, the most impor-
tant concepts are
• Actual age
• Useful life
• Remaining useful life
The use of these terms in the breakdown method emphasizes the separation of physi-
cal deterioration from functional and external obsolescence. The economic age-life
method employs economic life, which accounts for all three components of deprecia-
tion in one calculation. In contrast, the breakdown method employs useful life for
physical deterioration, which is separated into short-lived and long-lived building
components. The useful life of a building (i.e., the useful life of structural or long-
lived items) is typically longer than its economic life, while the short-lived compo-
nents have a useful life that is shorter than that of the whole building. (Unless there
are no short-lived items, it is logically impossible for the useful life of long-lived com-
ponents and the economic life of the property as a whole to be the same.) In spite of
that difference, the application of useful life in the breakdown method and economic

life in the market extraction and economic age-life methods should yield the same
approximate estimate of total depreciation.
Actual Age and Effective Age

Actual age, which is sometimes called historical age or chronological age, is the number of
years that have elapsed since building construction was completed. Actual age serves
two purposes in depreciation analysis. First, it is the initial element analyzed in the esti-
mation of effective age. Second, in the application of the breakdown method, the actual
age is a fundamental consideration in the age-life analysis needed to estimate physical
deterioration of the short-lived and long-lived components of an improvement.
Effective age is the age indicated by the condition and utility of a structure, and
an estimate of effective age is based on an appraiser’s judgment and interpretation
of market perceptions. Even in the same market, similar buildings do not necessarily
depreciate at the same rate. The maintenance standards of owners or occupants can
influence the pace of building depreciation. If one building is better maintained than
other buildings in its market area, the effective age of that building may be less than
its actual age. If a building is poorly maintained, its effective age may be greater than
its actual age. If a building has received typical maintenance, its effective age and
actual age may be the same.
As an example, consider a 23-year-old strip retail center that has been redecorat-
ed on the inside but has not been modernized. The original roof and HVAC compo-
nents are still in place. The building would probably have an effective age of about 23
years. (The small amount of work done in redecorating is usually not sufficient to re-
duce the effective age.) Now suppose that, in addition to the redecorating, the build-
ing’s roof and HVAC system have been replaced. In this case, the building would
probably have an estimated effective age of less than 23 years. If the same 23-year-old
building were in poor condition, had not been redecorated, had a defective HVAC
system, and had below-average occupancy because of poor maintenance, it would
probably have an estimated effective age greater than 23 years. The condition and
functional utility of an improvement as well as market and locational factors must be
taken into account in the process of estimating an improvement’s effective age.
Total Economic Life and Useful Life

An improvement’s total economic life begins when that improvement is built. It ends
when the improvement no longer contributes value for the use and is no longer the
highest and best use of the underlying land. This period is usually shorter than the
improvement’s physical life expectancy.2 At the end of a building’s economic life, a
property owner has two options available:
• Demolition and replacement with a suitable new structure
• Hold until one of the other options is economically feasible
Both economic life and useful life acknowledge that market forces operate in such
a way that buildings are either renovated, converted to a new use, rehabilitated,
remodeled, or torn down long before they physically wear out.
2. The concept of physical life is an outdated term that has persisted because its meaning is self-evident and easier to explain than the concepts of
useful life and economic life. The concept of useful life is more complex but more useful than physical life in the analysis of depreciation because
useful life includes a consideration of the economics of the use a structure was originally intended for.

All aspects of a property and its market, including the quality and condition of the
construction, the functional utility of the improvements, and market and locational
externalities must be considered in the estimation of a property’s economic life. The eco-
nomic life of an improvement is shaped by a number of factors, including the following:
physical considerations The rate at which the physical components of an improvement wear out,
given the quality of construction, the use of the property, maintenance
standards, and the region’s climate.
functional considerations The rate at which construction technology, tastes in architecture, energy
efficiency, and building design change. These factors can render an improve-
ment functionally obsolete, regardless of its age or condition.
external considerations Short-term and long-term influences such as the stage of a neighborhood’s
life cycle, the availability and affordability of financing, and supply and
demand factors (i.e., market conditions).
Many functional and external considerations may have no discernible effect on

the value of an improvement as recognized by the market on the date of the opinion
of value, but those considerations may have a profound effect at some future time—
say, in 20, 50, or even 100 years. Changes in market preferences and locational attri-
butes are not typically predictable or, for that matter, curable. Although it is difficult
to forecast economic life expectancy, market study and analysis of historical trends
and neighborhood life cycles may provide important information.
To estimate an improvement’s economic life, an appraiser studies the typical
economic life expectancy of similar improvements that have been sold recently in the
market area. The techniques used to develop an estimate of total economic life include
• Extracting depreciation from comparable sales (i.e., the market extraction method)
• Observing real estate cycles and changes in market preferences to establish the
length of time that similar properties are in demand and improvements are con-
tributing to market value
• Consulting with owners and developers regarding the feasibility of improve-
ments that extend a building’s economic life
• Considering the investment horizon used by buyers and sellers, to the extent that
it might be influenced by their anticipation of remaining economic life
• Interviewing property managers, leasing agents, and real estate brokers regard-
ing market preferences
• Reviewing public records, including building permits for new construction and
alterations, approved site and building plans, and other records for construction,
redevelopment, and renovation projects and approvals.
• Reviewing published cost services that report average economic lives by prop-
erty type
• Considering the effect that rising or falling land values will have on the remain-
ing economic life of the improvements
To calculate total economic life expectancy as of the date of sale, an appraiser
takes the reciprocal of the average annual depreciation rate. For example, consider a
residential subdivision where recent home sales indicate an average annual rate of
depreciation of 2% for properties that are very comparable to the subject property
(i.e., all homes built in the same phase of the subdivision’s development and sold
near the time of the sale of the subject property). Calculating the reciprocal of 2%

(100%/2%, or 1/0.02) results in a total economic life expectancy for the subject prop-
erty of 50 years as of the date of the opinion of value. This does not mean that the
total economic life expectancy of the subject has always been and will always be 50
years. Rather, at the time the property was sold, its average annual rate of deprecia-
tion indicated a total economic life expectancy of 50 years. The total economic life
expectancy of 50 years serves as a denominator in calculations that help explain the
total depreciation in a property at a given point in time.
Calculating total economic life from an estimate of the average annual rate of de-
preciation is common, but it is considered overly simplistic by critics who point out
the technique’s reliance on straight-line depreciation. Accounting for curvilinear pat-
terns of depreciation (e.g., compound rather than simple accrual) requires additional
data to support a more detailed, and possibly more realistic, model of the market
behavior of a building over its total economic life. Figure 31.1 illustrates various pos-
sible trends in depreciation graphed over time.
Renovation and modernization can effectively extend a building’s life expectancy
by “resetting the clock.” For example, consider an improvement with a 50-year econom-
ic life expectancy. If at the 10-year mark the improvement was substantially modernized,
bringing the physical components up to current market standards for new construction,
then the effective age could be reset to zero and the remaining economic life expectancy
of 40 years (before the renovation) would be reset to the original 50 years—or to some
other figure, depending on the extent of modification to the improvement. Many his-
toric properties have an economic life equal to or greater than the original physical life
expectancy of the building materials because of continued renovation and restoration.
Useful life is the period of time over which the components of the improvement
may reasonably be expected to perform the functions for which they were designed.
In the breakdown method of estimating depreciation, useful life is used in age-life
calculations. Although the physical life expectancy of some components, such as
structural elements made of concrete and steel, may be hundreds of years, the con-
cept of useful life recognizes the economic influences acting on the improvements
that contain these components. In more tangible terms, if a 40-year-old industrial
building is being demolished so that its site can be redeveloped, it is probable that all
components of the building will be demolished, regardless of their remaining physi-
cal utility.
The useful life of
Figure 31.1 Various Depreciation Trends short-lived physical
$500,000 components (e.g., HVAC
components, roof cover-
Replacement Cost
$400,000
ing, interior decorating,
Depreciated
$300,000
floor finishes) is shorter
$200,000 than the life expectancy
$100,000 of the entire building.
$0 Conversely, long-lived
0 10 20 30 40 50 components (usually the
Actual Age
structural components
Economic Life of 50 Years (Straight-Line Depreciation)
of a building, such as the
Straight-Line Depreciation with Refurbishment Every 10 Years
foundation, framing, and
Variable Depreciation
underground piping)

may have a life expectancy that is longer than the building’s economic life expec-
tancy. Distinguishing between short-lived and long-lived components is important
when breakdown techniques are applied, and the process of differentiation gives
appraisers flexibility in estimating component depreciation that is not available with
the market extraction and economic age-life methods.
Remaining Economic Life and Remaining Useful Life

Remaining economic life is the estimated period over which existing improvements
are expected to continue to contribute economically to property value. The concept is
applied in the economic age-life method. Usually improvements can be regarded as
investments designed to contribute to value over a long period of time. Some depre-
ciation occurs between the date when the improvements begin to contribute to value
and the date of the opinion of value. Wear and tear can take their toll even during
construction, which is usually a long process. The remaining economic life extends
from the date of the opinion of value to the end of the improvement’s economic life.
The remaining economic life is never more than its total economic life as long as the
highest and best use of the property does not change. In the breakdown method, total
useful life is the estimated period from the construction or installation of a compo-
nent to the end of its total useful life expectancy. The remaining useful life of any
long-lived item is greater than its remaining economic life, unless there are no short-
lived components or the short-lived components are already completely depreciated.
The total economic life of similar structures minus the effective age of the im-
provement will approximate the expected remaining economic life of the improve-
ments of the subject property. As an example, consider a property with a 15-year-old
building. An appraiser searches the market area and finds three sales of properties
that are comparable in size, layout, and other physical characteristics:
• Property 1 has an eight-year-old building, an annual depreciation rate of 2.0%,
and a total economic life expectancy of 50 years (100% ÷ 2%). Its remaining eco-
nomic life expectancy is therefore 42 years (50 - 8 = 42).
• In contrast, Property 2 has a 19-year-old building, an annual depreciation rate of
1.51%, and a total economic life expectancy of 66 years (1 ÷ 0.0151). Its remaining
economic life expectancy is 47 years (66 - 19 = 47).
• Property 3 has a 14-year-old building, an annual depreciation rate of 1.75%, and
a total economic life expectancy of 57 years (1/0.0175). Its remaining economic life
expectancy is 43 years (57 - 14 = 43).
A pattern can be observed. As a building ages, the total depreciation increases but
the average annual depreciation rate may also change. The remaining economic life
expectancy would increase if the effective age decreases over time due to periodic
repairs and maintenance. In other words, total economic life and its components do
not always remain constant. Reconciliation should be based on the improvement that
is most similar in age to the subject property. Of the three sales, the improvement
closest to the subject property in age is Property 3. In light of this similar sale and the
pattern indicated by the market data, the appraiser could reasonably reconcile the
total economic life expectancy for the subject property at 60 years. Using the eco-
nomic age-life method, which will be discussed in detail later in this chapter, the total
depreciation would equal 25% (15/60) of the property’s cost.

Patterns of Depreciation
The use of age and life estimates in calculations of depreciation percentages often involves a conclusion
that depreciation accrues at a constant rate, i.e., in a straight-line pattern. However, the rate and accelera-
tion of the accrual of depreciation over time can change based on a broad range of influences, resulting in
a concave, convex, linear, or other shape when value is graphed over time. A variable pattern of depreciation
(e.g., reflecting periodic refurbishment of short-lived building components) is likely the most realistic scenario
and does not rely on a straight-line conclusion.
Figure A illustrates a pattern of depreciation that can be exhibited by many types of buildings. As the building
ages, the average annual rate of depreciation decreases, resulting in a downward curve, until total depreciation
eventually levels off and the value of the improvement stabilizes at its salvage value. The economic life remains
relatively stable as routine maintenance occurs and the building continues to be used for its original purpose,
unless or until a competing use for the site raises the land value high enough to support demolition and redevel-
opment of the site. The building might also be converted to another use, supporting the concept that useful life
may begin again under another intended use. Conversely, the opposite situation could occur in markets that are
changing rapidly. As land value increases and as market preferences change to different designs or property types,
average annual depreciation accelerates and both economic life and useful life are shortened. Both situations
may occur over the life of the same improvement, which is why economic life and useful life estimates apply to
a specific point in time. Figure B depicts the depreciation curve in a market that is changing rapidly and exerting
upward pressure on land values. In contrast, Figure C illustrates a depreciation curve in a market where a severe
downturn affects land values sharply and is then followed by a long, slow recovery.
Figure A Analysis of Variable Depreciation and Value Change Over Time
$1,200,000
$1,000,000
$800,000
Value
$600,000
$400,000
$200,000
$0
0 5 10 15 20 25 30 35 40 45 50
Years
Market Value Building Contributory Value Land Value
Value change typical of older, stable neighborhoods.
Land value increase is steady but slow.
Value of the building declines and then stabilizes
Market value levels off and remains stable and later increases moderately.

Figure B Analysis of Depreciation and Value Change Over Time—Changing Market Conditions
$1,200,000
$1,000,000
$800,000
Value
$600,000
$400,000
$200,000
$0
0 5 10 15 20 25 30 35 40 45 50
Years
Rate of depreciation of building remains relatively constant while rate of appreciation of
land value accelerates significantly around Year 20.
Change in highest and best use around Year 28.
Building contribution declines to $0 around Year 47.
Building is demolished and property is redeveloped in Year 48.
Figure C Analysis of Depreciation and Value Change Over Time—Market Downturn
$1,200,000
$1,000,000
$800,000
Value
$600,000
$400,000
$200,000
$0
0 5 10 15 20 25 30 35 40 45 50
Years
Land value drops precipitously in Year 14 due to a change in market conditions and does
not recover significantly for many years.
Building contribution to value continues to decline steadily, causing market value to
continue to decline.

Market Extraction Method
The market extraction method of estimating total depreciation relies on the avail-
ability of comparable sales from which depreciation can be extracted. It makes use
of direct comparisons with sales of comparable properties in the market. While easy
to understand and explain, the market extraction method should only be used if
sufficient data exists and if the quality of that data is adequate to permit meaning-
ful analysis. By considering all elements in one calculation, market extraction can be
an oversimplification of the complex interplay of physical, functional, and external
causes of depreciation. The technique is primarily used to extract total depreciation
and to establish total economic life expectancy.
The market extraction method includes the following steps:
1. Find and verify sales of comparable improved properties that are similar in terms
of age and utility to the subject property. Although it is desirable, it is not essen-
tial that the comparable sales be current sales or be located in the subject proper-
ty’s area. They can be from a market that is comparable (i.e., similar age, design,
quality, functionality, and external influences).
2. Make appropriate adjustments to the prices of comparable sales for certain factors,
including property rights conveyed, expenditures made immediately after pur-
chase, financing, and conditions of sale, as appropriate. An adjustment for market
conditions is not made because the appraiser is estimating cost and depreciation at
the time of the sale. No adjustments are made for physical, functional, or external
impairments because these factors are the source of the depreciation that is being
measured and the comparable sales should be selected because they reflect similar
depreciation-related influences, the very items being measured here.
3. Subtract the value of the land at the time of sale from the sale price of each com-
parable property to obtain the contributory value of the improvements.
4. Estimate the cost of the improvements for each comparable property at the time
of its sale. The cost estimates should have the same basis—i.e., reproduction cost
or replacement cost. Typically replacement cost is used because an appraiser may
not have sufficient information on all the sales to develop a credible opinion of
reproduction cost. Also, the cost estimate should include all direct costs, indirect
costs, and entrepreneurial incentive for the improvements.
5. Subtract the contributory value of all improvements from the current construc-
tion cost to determine the total dollar amount of depreciation of the improve-
ments as of the date the sale occurred. The extracted depreciation includes all
forms of depreciation.
6. Convert the dollar estimates of depreciation into percentages by dividing each
estimate of total depreciation by the construction cost at the time of sale. If the
ages of the sales are relatively similar to the age of the subject property, the
percentages of total depreciation can be reconciled into a rate appropriate for the
subject property. This rate is applied to the subject’s cost to derive an estimate of
the subject’s total depreciation.
7. If the ages of the comparable properties are different from the age of the subject
property, then develop an annual depreciation rate. This step expands the analysis
to calculate annual rates of depreciation and to support an estimate of the total eco-

nomic life expectancy of the subject property. Note that if there is significant func-
tional or external obsolescence, this step will not necessarily be accurate since these
forms of depreciation are not necessarily related to the age of the improvements.
Consider the sales in Table 31.1. All are of fee simple estates and the ages, func-
tion, and external influences of the sale properties are similar to the subject prop-
erty. In this case, the range of total depreciation percentages is so narrow that it is
not necessary to annualize the calculations. The cost of the subject improvements is
$240,000 (more than the price of Sale 1 but much less than the price of Sale 3), so the
percentage of depreciation can be reconciled to 33% of cost. The total lump-sum dol-
lar depreciation estimate in Example 1 comes to $80,000 ($240,000 × 33%).
Table 31.1 Example 1

Step in
Sale 1 Sale 2 Sale 3 Procedure
Sale price $215,000 $165,000 $365,000 1, 2
Less value of land - $60,000 - $40,000 - $127,750 3
Depreciated cost of improvements $155,000 $125,000 $237,250 3
Cost of improvements $230,000 $195,000 $375,000 4

Less depreciated cost of improvements - $155,000 - $125,000 - $237,250 5
Total depreciation in dollars $75,000 $70,000 $137,750 5
Total depreciation percentage $75,000/$230,000 $70,000/$195,000 $137,500/$375,000 6
32.61% 35.90% 36.66%
If there are differences between the sales (e.g., location, amount of remodeling,
functional utility, degree of maintenance), total depreciation may show greater varia-
tion, and further analysis will be needed to understand the total depreciation. Ap-
praisers convert total depreciation into an annual depreciation rate by dividing each
percentage by the actual age of the sale property. The use of effective age instead of
actual age requires specific knowledge about the quality of construction and physical
characteristics of the improvements. Actual age may be preferred because it is a fact
that is readily available, whereas effective age is based on an appraiser’s judgment.
Whether actual or effective age is used, the same age basis must be applied consis-
tently to all sales. Then the appraiser analyzes the calculated depreciation rates and
compares the comparable sale properties to the subject property (if their effective
ages are different) in order to select an appropriate annual depreciation rate for the
subject improvements. Finally, the annual depreciation rate is multiplied by the age
of the subject property to develop an estimate of total depreciation. This procedure
can be misleading if there is significant functional or external obsolescence.
The comparable properties shown in Table 31.2 have a wide range of ages. Again
assume that all the sales are of a fee simple interest and that no major functional or
external obsolescence is evident.
In Example 2, the range of total percentage depreciation estimates is wide be-
cause of the age differences between the comparable properties. In this case, compar-
ing annual depreciation rates provide more credible support for the depreciation es-
timate. If the subject improvements are 15 years old, which is closest to the actual age

Table 31.2 Example 2
Step in
Sale 1 Sale 2 Sale 3 Procedure
Actual age of comparable property 8 14 19
Sale price $998,000 $605,000 $791,000 1, 2
Less value of land - $170,000 - $130,000 - $210,000 3
Depreciated cost of improvements $828,000 $475,000 $581,000 3
Cost of improvements $950,000 $627,000 $934,000 4

Less depreciated cost of improvements - $828,000 - $475,000 - $581,000 5
Total depreciation in dollars $122,000 $152,000 $353,000 5
Total depreciation percentage 9.68% 24.24% 37.79% 6
Actual age of comparable property 8 14 19
Average annual depreciation rate 1.60% 1.73% 1.98% 7
Total economic life expectancy 100%/1.60% 100%/1.73% 100%/1.98%
62.5 years 57.8 years 50.5 years
of the improvements in Sale 2, a reasonable estimate of annual depreciation would be

1.7% per year, which is within the calculated range of 1.60% to 1.98% for the compa-
rable properties. If this rate is applied to the subject property’s age, total depreciation
for the subject improvements can be calculated as 25.5% (15 × 1.7%).
The model can be further expanded to support an estimate of total economic life
expectancy for the subject property. The average annual depreciation for the subject
improvements equates to a total economic life of 58.8 years (100%/1.7%). This falls
within the range of the total economic life expectancies of the comparable properties,
50.5 to 62.5 years, and appears reasonable for the subject property.

When sales data is plentiful, the market extraction method provides a reliable and
convincing estimate of depreciation. However, appraisers must be able to develop
an accurate site value estimate and a defensible estimate of replacement cost for each
comparable property. Additionally, the comparable properties should ideally have
physical, functional, and external characteristics similar to the subject property, and
they should have incurred similar amounts and types of depreciation.
When the comparable properties differ in design, quality, or construction, ap-
praisers can find it difficult to judge whether differences in value are attributable
to these characteristics or to a difference in age, and thus depreciation. The market
extraction method is difficult to apply when the type or extent of depreciation var-
ies greatly among the comparable properties due to characteristics other than age.
Locational differences may be removed with the subtraction of land value. However,
external conditions can affect building values as well, which is why it is important to
select sales of properties that are subject to the same (or similar) market influences. If
the sales analyzed are affected by special financing or unusual motivation, the prob-
lem is further complicated.
The usefulness of the market extraction method depends on the accuracy of the
site value estimates and the cost estimates for the comparable properties. If the sales

are located in market areas that are not comparable to the subject property’s, the
location differences may cause the results to be less than credible. Market extraction
considers all types of depreciation in a lump sum and does not break down the esti-
mate into the various components of depreciation. However, this depreciation method
is market-based and easy to understand, and for these reasons provides meaningful
market-supported results when it can be appropriately supported.
Economic Age-Life Method

The effective age and total economic life expectancy of a structure are the primary
concepts used by appraisers to measure depreciation with age-life relationships. In
the economic age-life method, total depreciation is estimated by calculating the ratio
of the effective age of the property to its economic life expectancy and applying this
ratio to the property’s total cost. The formula is
Effective Age
× Total Cost = Depreciation
Total Economic Life
Although the economic age-life method is not always as accurate as other tech-
niques, it is the simplest way to estimate depreciation. The method is applied in the
following steps:
1. Conduct research to identify the anticipated total economic life of similar struc-
tures in the market area and estimate the effective age of the subject building.
The data used in the market extraction method would also be applicable in the
economic age-life method.
2. Divide the estimated effective age of the subject by the anticipated total economic
life of similar structures. The resulting ratio is then applied to the subject’s cost to
estimate total lump-sum depreciation.
3. Subtract the lump-sum estimate of depreciation from the total cost new of the sub-
ject improvement to arrive at the improvement’s contribution to property value.
As an example, market research (Step 1) yields the following information about a
subject and comparable properties:
Total cost new of subject property improvements $668,175
Land value of subject property $180,000
Estimated effective age of subject property 18 years
Total indicated economic life expectancy from comparable properties 50 years
The total percentage of depreciation is determined by dividing the estimated

effective age of 18 years by the total economic life expectancy of 50 years (Step 2).
Thus, the economic age-life formula indicates total depreciation of 36% (18/50). When
this rate is applied to the total cost new of subject improvements of $668,175, the total
depreciation indicated is $240,543 (Step 3). The cost approach calculations are applied
as follows:
Total cost new of subject improvements $668,175
Less total depreciation - $240,543
Depreciated cost $427,632
Plus land value of the subject property + $180,000
Indicated value by the cost approach $607,632

The economic age-life method is simple, easy to apply, and easy to understand. It
allows appraisers to estimate total depreciation, which can subsequently be allocated
among its various causes using breakdown procedures. Although this method is usu-
ally the simplest way to estimate depreciation, it does have limitations.
First, because the percentage of depreciation is represented by the ratio of effec-
tive age to total economic life, this method measures depreciation on a straight-line
basis over the course of an improvement’s economic life. The straight-line pattern
of depreciation is only an approximation of the total depreciation of a property at a
specific point in time.
Second, the economic age-life method, like the market extraction method, does
not divide depreciation into its various categories—physical deterioration and
functional and external obsolescence. In other words, obsolescence must be included
in the estimate of effective age or economic life. In market areas where comparable
properties incur types and amounts of depreciation that differ from the subject prop-
erty, the economic age-life method is difficult to justify.
Finally, the economic age-life method, like the market extraction method, does not
recognize the difference between short-lived and long-lived items of physical deteriora-
tion. Because a single figure reflects all the depreciation in the structure as a whole, vary-
ing amounts of deterioration in short-lived items are not directly indicated in the age-life
method. For example, a structure as a whole may be 20% depreciated except for the roof,
which, unlike the roofs of other properties in the neighborhood, is 90% depreciated. In
this situation, the breakdown method allows appraisers to make more refined analyses.
The economic age-life method is appropriate so long as the economic age and
remaining economic life can be reasonably estimated. For instance, when a property has
significant existing deferred maintenance it may not be inhabitable in its current condi-
tion. This makes any estimate of economic age or remaining economic life unreliable. In
such situations, the appraiser must separate the short lived deferred maintenance items
from the longer lived items to more accurately estimate depreciation. This variation of
the age-life method is known as the modified economic age-life method.
Variations of the Economic Age-Life Method

In some situations, the effect of certain items of depreciation on value is known or
can be easily and accurately estimated, and in those situations appraisers can apply
a variation of the economic age-life method that involves deducting those items from
the total cost before applying the age-life ratio. This type of variation of the economic
age-life method combines techniques from the market extraction and breakdown
methods with the traditional economic age-life method.
In the most common variation of the economic age-life method, known as the
modified economic age-life method, the cost to cure the curable items of depreciation
(both physical and functional) is known. Deducting curable items of depreciation
from the cost of improvements before the age-life ratio is applied mirrors what typi-
cal purchasers consider when deciding on whether to invest in a property. That is,
a potential buyer will first consider what items need to be fixed (and their hard and
soft costs plus an appropriate entrepreneurial incentive) before judging the price he
or she would be willing to pay given the wear and tear on the long-lived items. This
procedure is most meaningful when the subject property has curable depreciation not

typically found in the market at the time of appraisal. If the cost to cure is known, it
can simply be deducted from the total cost but would need to include an appropri-
ate entrepreneurial incentive as a part of the total cost to account for effort and risk
associated with undertaking the repair. When the curable items are dealt with first, an
appraiser may need to use a lower effective age or a longer remaining economic life
expectancy in calculating the modified economic age-life ratio.
For example, consider a 20-year-old home with a total building cost of $292,000.
Deferred maintenance has left the property uninhabitable in its present condition,
and the interior needs to be completely refurbished at a documented cost of $52,500
inclusive of an appropriate entrepreneurial incentive. Sales of similar properties
that were sold after being refurbished are used to extract a total economic life expec-
tancy of 50 years. In deriving an estimate of total economic life expectancy for each
comparable building, the appraiser uses an effective age that is 25% lower than the
building’s actual age because investors in the market report that they think that the
effective age of a building will be lower than its actual age once the interior has been
refurbished. This avoids any double-counting of depreciation. If the effective age is
15 years after the refurbishment, then value would be calculated as follows:
Total replacement cost of improvements $292,000
Less depreciation (15/50 = 30%) - $87,600
Value refurbished $204,400
Less cost to refurbish interior - $52,500
Cost as is $151,900
Plus land value + $50,000
Indicated value by cost approach $201,900
If the refurbished portion will be brand new but the remaining portion of the
improvements has an effective (and actual) age of 20 years, then the value would be
calculated as follows:
Total replacement cost of improvements $292,000
Less cost to refurbish interior - $52,500
Remaining cost $239,500
Less depreciation (20/50 = 40%) - $95,800
Value as is $143,700
In situations where external obsolescence is present, another variation of the

economic age-life method can be applied. If external obsolescence is affecting the
subject property and sales of properties in the subject market have incurred the same
external obsolescence, an appraiser should use the total economic life extracted from
these sales in the economic age-life ratio. However, if external obsolescence is affect-
ing the subject property but there are no sales in the subject market similarly affected,
an appraiser can estimate total depreciation and economic life without the external
obsolescence using the market extraction or economic age-life method and then esti-
mate external obsolescence using techniques from another approach (e.g., the income
capitalization approach). The estimated depreciation from the economic age-life
method and the estimated external obsolescence from the breakdown method would
be added together to arrive at an estimate of total depreciation.

As an example, consider a property in a district where there is an oversupply
of competitive properties. This glut of competitive space has resulted in a reduction
in rents, which an appraiser estimates to be a 10% loss to the value indication of the
building as a result of external influences. Until the oversupply is corrected through
the natural interaction of supply and demand, the property will continue to be af-
fected. The total cost new of a building improvement with an effective age of 10 years
is $696,000, and the land value is $200,000. The market extraction method, applied
to comparable properties in the subject property’s market a year earlier when there
was no oversupply, indicated a total economic life expectancy of 50 years. Using the
economic age-life method, depreciation is thus estimated at 20% (10/50).
The physical and functional depreciation estimated for the subject improvements
by the economic age-life method is $139,200 and the additional external obsolescence for
the building is estimated at $69,600. Total depreciation, therefore, is allocated as follows:
Depreciation attributable to all causes except external obsolescence
$696,000 × 20% $139,200
Depreciation attributable to the external obsolescence
$696,000 × 10% + $69,600
Total depreciation (or 30% of $696,000) $208,800
Replacement cost new of improvements $696,000
Less total depreciation - $208,800
Value of improvements $487,200
Note that the external obsolescence is caused by an oversupply in the market,

and it is unlikely that such a situation will be permanent. As supply and demand
again approach equilibrium, the oversupply should disappear.
Now suppose that the 10% loss in value due to external influences includes a
decline in land value estimated at $25,000. The losses in value to the land and the
improvements would be accounted for as follows:
Total external obsolescence $69,600
Less loss in land value - $25,000
External obsolescence to improvements $44,600
Total replacement cost new of improvements $696,000

Less physical deterioration - $139,200
Less external obsolescence - $44,600
Value of improvements $512,200
Plus land value (includes value lost from external influences
$200,000 - $25,000 = $175,000) + $175,000
The modified economic age-life techniques work best when relatively few adjust-
ments need to be made to the economic age-life method of estimating total deprecia-
tion. Usually, relatively nominal adjustments are made for curable physical items or
for a functional or external influence. If more than one atypical element exists in a
property, it may be advisable to use the more detailed breakdown method.

Figure 31.2 Components of Depreciation
Total Depreciation Estimate from Market Extraction or Economic Age-Life Method
Physical Deterioration Functional Obsolescence External Obsolescence
Curable? Incurable? Curable? Incurable?
Deferred Short-lived Long-lived Caused by Caused by Caused by Caused by

Maintenance Items Items Deficiency Superadequacy Deficiency Superadequacy
Requiring an Requiring
Addition Substitution
Total Depreciation Estimate from Breakdown Method
Depreciation Estimates
575
Breakdown Method
The breakdown method is the most comprehensive and detailed way to measure de-
preciation because it segregates total depreciation into individual component parts:
• Physical deterioration
• Functional obsolescence
• External obsolescence
Each step of the breakdown method calculates one type of depreciation. The process
is cumulative, with each step building on the results of the prior step until all forms
of depreciation have been considered. Alternatively, the depreciation calculation may
begin with the estimation of total depreciation by the market extraction or economic
age-life method and then apply the breakdown method to allocate total depreciation
into more precise components.
The primary techniques used to calculate the different types of depreciation
include
• Estimation of cost to cure, which is a measure used for curable physical dete-
rioration (deferred maintenance) and curable functional obsolescence. This cost
should include all cost inclusive of a reasonable entrepreneurial incentive.
• Application of the extraction method or of an age-life ratio to measure incurable
physical deterioration for both short-lived and long-lived components
• Application of the functional obsolescence procedure to estimate all types of
functional obsolescence
• Analysis of market data (paired data analysis, statistical analysis, or other tech-
niques), which may be used to identify and estimate functional obsolescence
caused by a deficiency or superadequacy as well as external obsolescence
• Capitalization of income loss or excess operating costs, which may be used to
estimate incurable functional obsolescence as well as external obsolescence
Table 31.3 shows how the breakdown method can be applied to allocate an estimate
of total depreciation among its various components or to develop a conclusion of
total depreciation by adding together estimates of each item of depreciation.

The breakdown method is primarily used when the scope of work of an appraisal
assignment requires that each form of depreciation be accounted for in the appraisal.
In addition to allocating lump-sum estimates of total depreciation among their vari-
ous components, the breakdown method is used when the market extraction and
economic age-life methods cannot be applied. This usually occurs when the multiple
elements of depreciation that exist in the subject property are not accurately re-
flected in available sales data and a closer analysis of these elements of depreciation
is required. The breakdown method may also be used when the economic age-life
method is too simplistic to account for the varied forms of depreciation present.
When using the breakdown method, appraisers should keep several cautions
and considerations in mind:
1. If the sum of all items of physical deterioration estimated using the breakdown
method is equivalent to the total depreciation derived from the market extrac-

Table 31.3 Procedures for Applying the Breakdown Method
Purpose To allocate a known estimate of total depreciation, developed with the market extraction or economic
age-life methods, among its various components
Procedure 1. Estimate total depreciation using the market extraction or economic age-life method.
2. Calculate all items of physical deterioration, add them up, and subtract the total from the lump-
sum depreciation estimate. The residual amount, if any, represents depreciation attributable to
functional and external obsolescence.
3. Calculate all items of functional obsolescence, add them up, and subtract that total from the
total amount of obsolescence. Any residual represents the depreciation attributable to external
obsolescence.
Purpose To develop an estimate of total depreciation one item at a time
Procedure 1. Calculate all items of physical deterioration, including deferred maintenance if present, using the
appropriate techniques and then add up all the estimates to arrive at total physical deterioration.
2. Calculate all items of functional obsolescence, again using appropriate techniques, and add these
estimates together to arrive at total functional obsolescence.
3. Calculate external obsolescence. When external obsolescence cannot be allocated from a lump-
sum estimate, it is calculated either through analysis of market data or by capitalization of income
loss. Sometimes part of the loss in property value is due to a decline in land value.
4. Add together all physical deterioration (including the cost to cure deferred maintenance), functional
obsolescence, and external obsolescence to arrive at an estimate of total depreciation.
tion or economic age-life methods, then no functional obsolescence or external

obsolescence is present.
2. If the sum of all items of physical deterioration and all items of functional obso-
lescence estimated with breakdown techniques is equivalent to the total depre-
ciation derived from the market extraction or economic age-life methods, then no
external obsolescence is present.
3 . If the sum of the items of depreciation estimated by the breakdown method sub-
stantially differs from the total depreciation derived from the market extraction
or economic age-life methods, all the methods applied should be reviewed as a
test of reasonableness.
The results obtained from the breakdown method and from the market
extraction or economic age-life methods may differ for a variety of reasons. The
total depreciation derived using the market extraction or economic age-life methods
might not accurately reflect the characteristics of the depreciation in the subject
property. For example, the subject property may have an element of depreciation that
is indicated in the breakdown method but not in the market extraction or economic
age-life methods due to dissimilarities in the comparable data. Conversely, the
breakdown method may not be as accurate as the simpler methods of estimating
depreciation if certain breakdown techniques are applied incorrectly, resulting in
double-counting some element of depreciation. As another example, selecting a
useful life for the long-lived components that is the same as the economic life of
the property overall would be inappropriate in the breakdown method unless the
property had no short-lived components.

Physical Deterioration
In the breakdown method, all physical depreciation of improvements falls into one of
three categories:
• Deferred maintenance
• Short-lived physical deterioration
• Long-lived physical deterioration
Deferred maintenance is generally curable, whereas short-lived and long-lived items
of physical deterioration are not curable, usually because it is not physically possible
or economically feasible to cure them. Elements of total depreciation that are not phys-
ical deterioration must be some form of obsolescence (either functional or external).
Curable Physical Deterioration—Deferred Maintenance

Curable physical deterioration, also known as deferred maintenance, applies to items
in need of immediate repair on the effective date of the appraisal. Some examples
include broken windows, a broken or inoperable HVAC system, finished floor cover-
ings in need of immediate replacement, a leaking roof, and inoperable restrooms. For
most properties, deferred maintenance involves relatively minor items that are 100%
physically deteriorated (i.e., broken). The item must be replaced or repaired for the
building to continue to function as it should and to be marketable to potential buyers.
Because these repairs must be performed for the building to continue to function for
the intended use, they are curable items.
Deferred maintenance is measured as the cost to cure the item or the cost to re-
store it to a new or reasonably new condition. The cost to cure may exceed the item’s
cost when it was installed new. Cost to cure is analogous to an age-life procedure
because the age of a curable item equals (or exceeds) its total useful life expectancy,
resulting in 100% deterioration. All deferred maintenance items are completely dete-
riorated, and therefore they may all be treated together in the breakdown method.
For example, suppose that during a site visit to a small office building an ap-
praiser notes that the exterior walls need to be scraped, primed, and painted, and
one inoperable window needs to be replaced. A painting contractor quotes a price of
$5,000 to do the work. However, according to the appraiser’s cost manual, a similar
job performed at the present time—i.e., as part of an original construction project—
should only cost $3,500. In this instance the correct measure of the cost to cure is
$5,000. If the painting were done during the original construction, the walls would
not have had to be scraped. The contractor could have just primed and painted them.
Similarly, the cost of installing one window at the time of construction would be
$500, but the cost to replace the broken window is higher, $750 in this case, because of
the additional labor involved in removing and disposing of the existing window. The
higher amounts should be used by the appraiser as the cost to cure and the appropri-
ate measure of curable physical deterioration for these building components:
Current Construction Cost Cost to Cure
Painting $3,500 $5,000
Window + $500 + $750
Total $4,000 $5,750
Curable physical deterioration: $5,750

Repainting essentially resets the clock on the useful life of the paint, but the
repair of the broken window only affects the useful life of one of the building’s
windows. The other windows may have depreciated by a certain percentage due to
age, but replacing those other windows is not yet considered curable because those
improvements still contribute more value than new replacements windows would
after considering the cost to cure. The depreciation of the other windows would not
be deferred maintenance, but rather incurable physical deterioration.
Appraisers should note also that substantial deferred maintenance items typical-
ly require lump-sum adjustments in the sales comparison and income capitalization
approaches because these problems are specific to the subject property and would
not be reflected in the values provided by comparable sale or comparable rental
properties with routine maintenance. In other words, significant deferred mainte-
nance items are usually atypical expenses that require a capital decision by a prop-
erty owner rather than a routine repair handled by a property manager.
Incurable Physical Deterioration—Short-lived Items

Once any curable physical deterioration is estimated, the remaining physical dete-
rioration is allocated to either short-lived or long-lived building components. Short-
lived items are those that are not ready to be replaced on the date of the opinion of
value but will probably have to be replaced in the foreseeable (i.e., whatever is con-
sidered short-term) future. Examples include the roof covering, interior floor finish,
furnaces, and water heaters. At the current time, a short-lived item is not 100% physi-
cally deteriorated, so it does not yet need to be cured. However, an appraiser should
draw the same conclusions that market participants do—i.e., that the items will be
100% deteriorated before the end of the building’s remaining useful life expectancy
and will have to be replaced. When those items reach the point of 100% physical de-
terioration, they become curable items. Unlike items of deferred maintenance, which
have lasted beyond their useful life expectancy and need to be replaced immediately,
short-lived items have not reached the end of their total useful life expectancy and
are not completely deteriorated, but they are substantially depreciated in comparison
with the overall structure.
The deterioration in short-lived items is measured by estimating a separate age-
life ratio and applying it to the current cost of each short-lived item. Because each
short-lived item usually has a different age and a different total useful life expec-
tancy, a separate age-life ratio or schedule must be calculated for each item. Age-life
ratios for individual components are generally easier to estimate and support with
market data than the age-life ratio for the property as a whole used in the economic
age-life method.
As an example, consider a 20-year-old boiler in an apartment building. Accord-
ing to a boiler contractor, the total useful life expectancy of a boiler such as this is 25
years. On the date of the opinion of value, the boiler is operational and there is no
need to replace it. However, a prudent purchaser or owner would anticipate that the
boiler will have to be replaced within a few years. The replacement cost of the boiler is
$30,000. The age-life ratio is used to estimate a depreciation rate of 80% (20/25 = 0.80).
When this ratio is applied to the cost to replace the boiler ($30,000), the deterioration
indicated is $24,000 ($30,000 × 0.80). The boiler would not be a short-lived item if its
remaining useful life were equal to or greater than the remaining economic life of the
overall property.

The age of short-lived items may be the actual age or the effective age. In some
circumstances, effective age could be more appropriate depending on the degree of
maintenance or amount of wear and tear. The useful life may be developed from a va-
riety of sources, including observation, historical data, published cost surveys, manu-
facturer’s warranties, and discussions with builders, property managers, and others.
Many lenders and investors rely on property condition surveys to help them plan
for future replacements of building components. These surveys can be useful to ap-
praisers as well because they are usually prepared by an engineer and provide all of
the detail required to complete a breakdown depreciation analysis, including identifi-
cation and allocation of long- and short-lived components and the calculation of their
current age and remaining useful life. Property condition surveys include replacement
cost estimates and a 10- to 20-year schedule that indicates exactly when replacements
will be required. They tell the property owner what expenditures are needed immedi-
ately, what replacements will be needed in future years, and how much they will cost.
Incurable Physical Deterioration—Long-lived Items

Long-lived items include all items that were not treated as items of deferred mainte-
nance or as short-lived items. Long-lived items have the same age and life expectancy
and, therefore, they are all treated together. Examples of long-lived items include
exterior walls, structural framing, the roof structure, underground piping, foundation
walls, and insulation. Unless an improvement has reached the end of its useful life,
long-lived items are not 100% physically deteriorated and therefore do not need to be
cured. In addition, long-lived items are not normally replaced except under extraordi-
nary circumstances—e.g., if a foundation wall is damaged. In that case, the long-lived
component becomes an element of curable physical deterioration. The deterioration
of long-lived items is measured by estimating an age-life ratio and applying it to all
components of cost that have not already been treated for physical deterioration.
As an example, consider a small industrial building with a total cost of $700,000. It
is 35 years old and and the useful life expectancy of the long-lived components of the
building is 100 years. The cost to cure the curable items (deferred maintenance) is $10,000.
Short-lived building components include the boiler, roof cover, and floor covering. The
cost to replace the boiler is $40,000, the cost to replace the roof covering is $60,000, and the
cost to replace the floor finish is $20,000. There are no other short-lived items. The age-life
ratio is calculated to be 35% (35-year actual age/100-year useful life). The replacement cost
of the long-lived items is estimated by deducting the cost to cure the curable items and
the sum of the costs to replace the short-lived items from the cost of the structure:
Total replacement cost of improvements
(both long and short-lived items) $700,000
Deferred maintenance - $10,000
Short-lived items replacement cost
Boiler 40,000
Roof covering 60,000
Floor finish + 20,000
Subtotal—replacement cost of short-lived items - $120,000
Remaining replacement cost attributed to long-lived items $570,000
The age-life ratio is then applied to the untreated costs (35% × $570,000), and the
resulting amount of deterioration attributable to the long-lived items is calculated to

be $199,500. This represents only the depreciation attributable to the long-lived items.
The total depreciation estimate would have to include depreciation attributable to
deferred maintenance and short-lived items.
Note that each cost should include its share of entrepreneurial incentive and soft
costs. Appraisers should also be careful to avoid deducting the depreciation of short-
lived components, rather than their cost, in developing the replacement cost of the
long-lived components. Although the deferred maintenance shown in the preceding
table will appear as depreciation on the cost approach summary, it is also most often
calculated as the replacement cost of a fully depreciated item and in that case must
be included with the short-lived replacement costs before it can be deducted from the
total replacement cost as depreciation.
Understanding Age-Life Relationships and the Breakdown Method

Figure 31.3 illustrates a procedure that can be used to estimate all forms of physical
deterioration, both curable and incurable. In addition to showing the correct relation-
ship between all items of physical deterioration, the diagram is designed to ensure
that all types of physical deterioration are considered and that no items of physical
deterioration are treated more than once. This age-life procedure works whether
the breakdown method is being used to allocate a known total depreciation amount
among its components or to develop an estimate of total depreciation.
The procedure has four steps. First, the total cost is allocated among the curable
items, the incurable short-lived items, and the incurable long-lived items (Row C of
Figure 31.3). Second, an age-life ratio is calculated for each allocated cost item (Row
D). Third, the appropriate age-life ratio is applied to the estimated cost of each item
(Row E). Finally, the individual items of physical deterioration are added together to
develop an estimate of total physical deterioration (Row F).
As an example of these calculations, consider a 25-year-old industrial building in
average condition, illustrated in Figure 31.4. The overall cost is $800,000. On the date
of the site visit, the appraiser found one overhead door damaged beyond repair, which
will cost $5,000 to replace. (In this case, the $5,000 cost to cure is the original cost of
the installation of the door, i.e., there is no excess cost to cure.) The roof was replaced
five years ago and has a 20-year guarantee, which indicates that it is 25% depreciated.
The cost to replace it is $60,000. The original HVAC components should last another
Figure 31.3 Age-Life Procedure for Estimating All Items of Physical Deterioration
A Overall Cost
B Curables Short-lived Item 1 Short-lived Item 2 Short-lived Item n Long-lived Items
C Cost to Cure Cost to Replace Cost to Replace Cost to Replace Untreated Costs
× × × × ×
D 100% Age-Life Ratio Age-Life Ratio Age-Life Ratio Age-Life Ratio
= = = = =
E Deterioration Deterioration Deterioration Deterioration Deterioration
F Total Physical Deterioration

Figure 31.4 Age-Life Estimation of Physical Deterioration
A $800,000
B Curables Roof Cover HVAC Components Decorating Long-lived Items
C $5,000 $60,000 $72,000 $10,000 $653,000

× × × × ×
D 100% 25% 831⁄3 0% 25%
= = = = =
E $5,000 $15,000 $60,000 $0 $163,250
F $243,250
five years, which indicates they are 831⁄3% deteriorated (25/30). The cost to replace the
HVAC components is $72,000. The offices were just completely redecorated at a cost
of $10,000. An appraiser estimates that the offices will not have to be redecorated for
another five years. Based on an analysis of demolition permits, the appraiser concludes
that the total useful life expectancy of the long-lived items is 100 years.
In this example, the total physical deterioration is the sum of the individual dete-
rioration calculations, or $243,250. On an age-life basis, the total depreciation is about
30%. The average annual physical depreciation is 1.2% per year and the economic life
is 83 years (assuming that the improvements so not suffer from functional or external
obsolescence). The total depreciation of short-lived items is $80,000 and the current
cost of these items is $147,000.
A summary of the depreciated cost of the improvements is shown below:
Total current cost of all improvements $800,000
Less depreciation
Short-lived components $80,000
Long-lived components + $163,250
Total depreciation - $243,250
Depreciated value of building improvements $556,750
Damage or Vandalism
Damage or vandalism requires special treatment in the estimation of depreciation. The measure of damage is
the cost to cure, but damage or vandalism must be treated separately from other forms of physical deterio-
ration because, unlike deferred maintenance, damage is not considered in the estimate of cost new. When
damage or vandalism is cured, the life of the damaged component is neither renewed nor prolonged. It is
simply restored to its condition prior to the damage.
As an example, consider a brick wall that has been spray-painted with graffiti. The cost of sandblasting the
wall to remove the graffiti is $5,000. Nowhere in the overall cost new of the original construction is there a pro-
vision for the removal of graffiti. The measure of damage in this instance would be $5,000, the full cost to cure.
Typically, the cost to cure damage is added to the curable physical deterioration and included among
the items of physical deterioration in the breakdown method. However, the $5,000 cost to cure damage or
vandalism is not subtracted from cost when calculating long-lived physical deterioration.

Functional Obsolescence
Functional obsolescence is caused by a flaw in the structure, materials, or design of
an improvement when the improvement is compared with the highest and best use
and the most cost-effective functional design requirements at the time of the ap-
praisal (what is known in appraisal as the ideal improvement). A building that was
functionally adequate at the time of construction can become inadequate or less ap-
pealing as design standards, mechanical systems, and construction materials evolve.
Functional obsolescence is attributable to defects within the property lines, in
contrast to external obsolescence, which involves conditions outside the property
lines and therefore outside the control of the owner and occupants. Functional obso-
lescence, which may be curable or incurable, can be caused by a deficiency—that is,
some aspect of the subject property is below standard in respect to market norms. It
can also be caused by a superadequacy—that is, some aspect of the subject property
exceeds market norms.
In some cases, a developer or property owner creates functional obsolescence by
incorporating special features at the request of the occupant that would not appeal
to the market in general. An example of a superadequacy is an expensive, in-ground
swimming pool in a neighborhood of relatively low-cost homes. Equally common is
functional obsolescence that occurs as a result of changing tastes or market prefer-
ences. Too few bathrooms in a residence or warehouse ceiling heights that are below
current standards are examples of functional obsolescence due to deficiencies.
Characteristics of the different types of functional obsolescence are illustrated
in Table 31.4. Elements of depreciation not identified as physical deterioration or
functional obsolescence must be external obsolescence, which is discussed later in
this chapter.
Like the curability of physical deterioration, there are two major tests of curabil-
ity for functional obsolescence caused by a deficiency or superadequacy:
• If spending the money to cure the item will result in a value increment equal to
or greater than the expenditure, the item is curable.
• If spending the money to cure the item will not result in a value increment equal
to or greater than the expenditure but will allow existing items to maintain their
value, the item is again curable.
If the cost to cure the item will not result in a value increment greater than the loss in
value caused by the item or building component, then the item is incurable. Func-
tional obsolescence can be corrected in two ways:
• The functional obsolescence is cured by the property owner when this is econom-
ically feasible.
or
• Market norms change, eliminating the cause of the functional obsolescence. In
other words, the functional obsolescence no longer exists.
Problem-Solving for Functional Obsolescence

Estimating the effect of functional obsolescence is rarely as straightforward as
estimating the effect of physical deterioration because judging the relative utility of
building improvements is more difficult than accounting for immediately apparent
physical losses. However, the process of identifying and selecting an appropriate

Table 31.4 Types of Functional Obsolescence
Type Characteristics/Measure
Curable deficiency requiring The subject property has functional obsolescence because it does not have
an addition something that other properties in the market do have. Because the item is not
present, the property cannot be penalized for any deterioration that the item
would have incurred if it had been included in the original construction.
However, because it usually costs more to add an item to an existing property
than to include it when the property was originally built, the excess cost to cure
is the appropriate measure of functional obsolescence.
Curable deficiency requiring A curable deficiency requiring substitution or modernization is caused by
substitution or modernization something that is present in the subject property but is either substandard
compared to other properties in the market or is defective and thereby prevents
some other component or system in the property from working properly. The
measure is the excess cost to cure. In addition, the depreciated or remaining
cost of the existing item, which is now worthless, must be deducted.
Curable superadequacy A superadequacy is a type of functional obsolescence caused by something in
the subject property that exceeds market requirements but does not contribute
to value an amount equal to its cost. The superadequacy may have a cost to
carry (i.e., higher operating costs) that must be considered. A superadequacy
is only curable if it can be removed and the value that is added (or costs reduced),
including any salvage value for its removal, is greater than the cost to cure.
Incurable deficiency The subject property has functional obsolescence because it is missing a
building component or design feature (e.g., a warehouse with unusually low
ceilings) that is not economically feasible to correct.
Incurable superadequacy An item of incurable functional obsolescence caused by a superadequacy is a
property component that exceeds market requirements. It represents a cost
without any corresponding increment in value or a cost that the increment in
value does not meet. Note that in some applications of the cost approach, the
need to estimate the functional obsolescence attributable to an incurable
superadequacy is eliminated by using replacement cost instead of reproduction
cost because superadequacies are not replicated in a replacement cost
estimate. Nevertheless, whether replacement or reproduction cost is used, any
extraordinary expense of ownership associated with the superadequacy is
quantified and deducted as a penalty from the value of the property. Essentially,
the property loses value through the added costs of ownership over time
because the component is incurable. However, if the cost of ownership
increases over time, the obsolescence may become curable.
treatment for a functional problem is simplified when the problem is broken down
into manageable tasks using the framework illustrated in Figure 31.5. The first step
is to identify the functional problem. In many cases this is readily apparent from the
site visit and information from the highest and best use analysis or other analyses in
the valuation process. Once the functional problem has been identified, the next step
is to determine which building components are causing the problem and identify
possible corrective measures (and the associated costs to cure).
In many cases, only one cost-to-cure program will clearly identify the course of ac-
tion to fix or improve a functional problem. Often there may be no economically feasi-
ble or practical method to cure the problem. (This is true especially for superadequate
components.) In these cases the component is incurable and the property must endure
the loss in value. If there are multiple cost-to-cure alternatives to fix a particular prob-
lem, an appraiser should select the most appropriate and cost-effective measure.

Figure 31.5 Analyzing a Functional Problem
1. Identify the functional problem.
2. Identify the component (or components) in the facility, or the lack of a component (or components), associated
with the problem.
3. Identify possible corrective measures and the related costs to cure, including entrepreneurial incentive.
4. Select the most appropriate corrective measure.
5. Quantify the loss caused by the functional problem.
6. Determine if the item is curable or incurable. (If the added value is equal to or greater than the cost to cure, the
functional problem is curable.)
7. Apply the functional obsolescence procedure to calculate the amount of depreciation caused by the functional problem.
The Curability and Incurability of Functional Issues

The test of curability is simply a comparison of the value added to the improvement if the functional problem
is corrected with the cost to cure the functional problem of that improvement. If the value added is greater
than the cost to cure, the functional problem is curable. If the value added is less than the cost to cure, the
functional problem is incurable.
In the simplest terms, the value added is the amount that the market value of the real estate increases if
a specific item is fixed. The value added is not the value of the item but rather the value that will be added to
the property if the functional problem is fixed. As an example, suppose a recently built home was designed
with a standard forced-air heating system with a natural gas furnace. In the five years since the house was
built, high-efficiency gas furnaces have begun to replace less-efficient standard models in new homes in the
subject property’s neighborhood. Paired data analysis of a large pool of data comparing the recent sale prices
of houses with high-efficiency furnaces and those with standard heating systems indicates a $3,000 premium
for houses with a high-efficiency heating system in place. That $3,000 premium would be the value added for
the subject property if the standard heating system were to be replaced with a more modern system.
The cost to cure is the amount that must be spent to correct the functional problem. In this case, esti-
mates for the removal of a slightly depreciated heating system and replacement with a high-efficiency system
average around $3,500, including all direct costs, indirect costs, and entrepreneurial incentive. The cost to
cure of $3,500 is greater than the $3,000 value added, so the functional issue would be incurable. However,
suppose that the existing heating system had a salvage value of $500 and a governmental incentive program
promoting the installation of high-efficiency heating systems offered a $500 rebate on the installation cost of
a new system. Then the total cost to cure would be $2,500 ($3,500 - $500 - $500), which would be less
than the value added, making the functional problem curable.
Most curable functional obsolescence is caused by some form of deficiency like the heating system of the
house that is currently below the emerging standard for energy efficiency, but some superadequacies can be
treated as curable depreciation. As an example, suppose that the presence of a swimming pool in an apart-
ment building does not mean that additional rent can be charged for the units. The swimming pool would be
an overimprovement and thus an item of functional obsolescence. If this swimming pool costs $5,000 per
year to operate, that $5,000 would be an expense deducted from the income generated by the property. At
a market-derived overall capitalization rate of 8%, the loss of $5,000 in net income results in a $62,500
($5,000/0.08) penalty to the value of the property. In other words, curing the functional problem of the un-
necessary swimming pool would increase the market value of the apartment building by $62,500.
Now assume the problem of the unwanted swimming pool can be corrected for $10,000 by filling the pool
and landscaping the area, with maintenance expenses reduced from the $5,000 to $500. The $500 loss in
net income would only penalize the value of the property $6,250 (at the same 8% capitalization rate), so the
total benefit to the property of removing the swimming pool would be $56,250 ($62,500 - $6,250). Clearly,
the value added of $56,250 is greater than the cost to cure of $10,000, so the functional problem of a swim-
ming pool amenity that does not make apartment units more desirable to potential tenants is a curable issue.

The cost to cure must account for the cost to tear out or replace the existing
component, the cost of the correct replacement component, any other costs above and
beyond the total cost if the component had been included in the initial construction,
and any salvage value. The total replacement cost for the component must include
any appropriate indirect costs and entrepreneurial incentive. Essentially, the final
measure is the total cost to cure offset by any salvage value:
Cost to tear out or remove existing component
+ Cost of correct replacement component (including entrepreneurial incentive)
+ Any costs above and beyond total cost if included in initial construction
- Salvage value (if any)
= Cost to cure
The next step is to quantify the loss caused by the functional problem associated
with the building component. The value loss could be caused by a loss in income, an
increase in expenses or operating costs, or a combination of both. Alternatively, the
value loss might be quantified by market evidence such as paired data analysis. By
definition, the loss cured will equal the value added once the cure is accomplished.
Note that the value added is not the same as the value referred to in the fourth step of
the functional obsolescence procedure (Figure 31.6).
Figure 31.6 Procedure for Estimating All Forms of Functional Obsolescence

Step 1. Estimate amount of component included in cost $xxx,xxx
Step 2. Subtract any physical deterioration charged - $xxx,xxx
Step 3. Add whichever is less:
a. cost to cure (all costs) + $xxx,xxx
or
b. value added (or value of loss) + $xxx,xxx
Step 4. Subtract cost as if included in new construction or value* - $xxx,xxx
Step 5. Equals depreciation from functional obsolescence $xxx,xxx
* Sometimes an existing item has value unrelated to cost.
Next the cost to cure is compared with the quantified loss. If the value added (once
the cure is accomplished) is greater than the cost to cure, then the functional problem
is curable. Otherwise, the functional problem is incurable. The next step is to solve for
the dollar amount of depreciation using the functional obsolescence procedure.
Using the Functional Obsolescence Procedure

Figure 31.6 diagrams a systematic procedure that can be used to calculate all forms
of functional obsolescence caused by a deficiency or a superadequacy, whether the
functional issue is curable or incurable. Use of this model helps ensure that all com-
ponents of functional obsolescence will be treated in a consistent manner, that none
of the items will be treated more than once, and that no double charges will be made
for items that have already been depreciated (i.e., charged under physical deteriora-
tion), which is particularly important for superadequacies.
First, the cost of the existing item is identified. If the item is a form of functional
obsolescence caused by a deficiency requiring an addition, there will be no cost for

the item and zero will be entered on this line. If the item is a deficiency requiring
rehabilitation or retrofit, there will be a cost for the item. Also, when replacement
cost, rather than reproduction cost, is used as the cost basis, typically there will be no
cost allotted for any superadequate items because such items would not be included
in replacement cost. As stated earlier in the text, all forms of functional obsolescence
present in the subject property would be included in a reproduction of that property,
whereas a replacement structure is built to contemporary standards and would not
have certain forms of obsolescence present in the subject improvement.
In the second step, any depreciation that has already been charged for the item is
deducted. In nearly all instances, this depreciation will be physical deterioration. As
in the first step, if the item does not already exist in the building, no depreciation will
have been charged and zero will be entered on this line.
Regardless of the type of functional obsolescence, appraisers always investigate a
cost to cure in order to determine whether an item is curable or not. In the third step
of the functional obsolescence procedure, the sum of all costs associated with curing
the item is compared to the value added as a result of curing the functional obso-
lescence. The cost to cure includes the cost of purchasing and installing a new item
(including entrepreneurial incentive) and the cost of removing the old item, less any
salvage value. The amount of the value added by curing the item can be obtained by
capitalizing an income gain that would result from curing the item (using an income
multiplier or a capitalization rate) or through analysis of market data such as paired
sales. If the value added by curing the item is greater than the cost to cure, then the
item is curable. If the value added by curing the item is less than the cost to cure, then
the item is incurable. In the latter case, curing the item of functional obsolescence is
physically possible, but the economic benefit of curing the item is outweighed by the
cost to cure.
In the application of the functional obsolescence procedure, the amount recorded
in the third step depends on whether the item is curable or incurable. If the item is
curable, the amount recorded is the cost to cure. If the item is incurable, the amount
recorded is the value that would be added if it was feasible to cure the item.
The fourth step of the procedure involves the cost of the item if it were included
as part of new construction, i.e., the proper item’s contribution to the replacement
cost (or reproduction cost) if it had been part of the original design rather than being
the source of a functional problem. For a curable item, that cost is essentially deduct-
ed from the cost to cure in the third step to calculate the item’s excess cost to cure. If
the item is incurable, the depreciated cost listed in the fourth step is deducted from
the value of the loss listed in the third step to yield the value added over and above
the cost of the item if installed in new construction.
In the final step, appraisers add up all of the entries to derive the total functional
obsolescence attributable to each factor. The model described here works for all types
of functional obsolescence.
Examples of a Deficiency
Some examples of deficiencies include
• Inadequate HVAC
• Interior finish that is lower quality than the exterior
• No landscaping where the market requires it

• Hallways that are too narrow
• Access points that are not ADA-compliant
Consider a small office building without air-conditioning in a market where this
feature is standard. Because of retrofit requirements, it is more costly to install the air-
conditioning now than it would have been as a part of the original construction. The
current cost to install the air-conditioning is $12,000. If the work had been done as a
part of new construction, the cost would have been only $10,000. Installing air-con-
ditioning would allow the property owner to raise rents, and effective gross income
would increase an estimated $2,000 per year. The current effective gross income mul-
tiplier (EGIM) is 7.0. The functional obsolescence is curable because the value added
($2,000 × 7.0 = $14,000) is greater than the cost to cure ($12,000).
Note that in the calculations shown in Table 31.5, because the air-conditioning is
not present in the existing improvement, no cost is shown as the cost of the existing
item and no depreciation was charged (Steps 1 and 2). The actual cost to retrofit and
install the air-conditioning is $12,000 (Step 3). However, the cost to install the air-condi-
tioning as a part of new construction on the date of the opinion of value is $10,000 (Step
4). The curable functional obsolescence is the excess cost to cure, or $2,000 (Step 5).
Now suppose that installing an air-conditioning system in the office is not eco-
nomically feasible—e.g., the current cost of the necessary renovations (say, $20,000) is
greater than the value gained by adding the item ($14,000). In the analysis of func-
tional obsolescence, two elements must be identified for each building component:
• The cost to cure
• The amount of loss caused by the component or the lack of the component
When the loss is cured, the amount of the loss essentially becomes the value added.
In this case, the cost to cure is $20,000. If the item is cured, the value added (or
reduction in loss) is only $14,000, which means the item is incurable. In the calcula-
tions shown in Table 31.6, the value of the loss ($14,000) is less than the cost to cure
($20,000) in Step 3. The depreciation charged is the amount of the loss, over and
above the cost if installed new. In the previous example, the item was curable and the
measure of depreciation was the excess cost to cure.
Again, because the air-conditioning is not present in the existing improvement,
no deterioration was charged. The value of the loss is equivalent to the lost income
attributable to the deficiency. The effect of this loss is partially offset by the $10,000
that would have been expended to install air-conditioning as part of new construc-
tion. In other words, this building is losing $14,000 as a result of the lack of air-
Table 31.5 Curable Deficiency: Install Air-Conditioning System

1. Amount of component included in cost $0
2. Less any physical depreciation charged - $0
3. Plus
a. cost to cure (all costs) + $12,000
or
b. value added
4. Less cost if included in new construction or value - $10,000
5. Equals depreciation from functional obsolescence $2,000

Table 31.6 Incurable Deficiency: Absence of Air-Conditioning System
3. Plus
a. cost to cure (all costs)
or
b. value of loss + $14,000
conditioning, but, in the calculation of depreciation, it saved the $10,000 expense of

installing the air-conditioning in the original construction. The incurable functional
obsolescence is $4,000.
Now suppose that the value added is $7,000 instead of $14,000. The item is still
incurable (see Table 31.7). The inclusion of air-conditioning is not economically fea-
sible in this case.
Costs to cure and losses sustained by a component can and do change over time.
Items identified as incurable at one point in time can become curable and vice versa
over the life of the property. Now suppose that the office building has an outdated
air-conditioning system that does not meet market standards and needs to be retro-
fitted. The reproduction cost of the existing air-conditioning system is $8,000, and
the item is 25% physically deteriorated ($8,000 × 0.25 = $2,000). The cost to remove
the existing air-conditioning is $4,500, the salvage value of that equipment is $3,000,
and the current cost of installing an appropriate air-conditioning system is $12,000
($10,000 to install the correct component plus $2,000 to retrofit the space). The prop-
erty can still be expected to increase effective gross income by $2,000 per year (with
an EGIM of 7.0) if an appropriate air-conditioning system is installed, so the extra
value generated ($14,000) would exceed the cost to cure ($4,500 - $3,000 + $12,000 =
$13,500) and the item is therefore curable. If the correct air-conditioning system had
been installed as part of new construction, the cost would have been $10,000.
In Table 31.8, application of the formula essentially removes the existing compo-
nent from cost (the $8,000 cost of the existing equipment less physical depreciation of
$2,000 already charged) in the first two steps and penalizes cost by the excess cost to
cure of $3,500 ($13,500 - $10,000) in the third and fourth steps.
Table 31.7 Incurable Deficiency: Absence of Air-Conditioning 2

3. Plus
or

Table 31.8 Curable Deficiency: Air-Conditioning Retrofit
1. Amount of component included in cost $8,000
2. Less any physical depreciation charged - $2,000
3. Plus
a. cost to cure (all costs) + $13,500
or
b. value added
Suppose that the existing equipment had no salvage value. The cost to cure the
deficiency shown in Table 31.9 ($4,500 for removal of existing equipment plus $12,000
for installation of the new system, or $16,500) would exceed the value gained by re-
placing the air-conditioning system ($14,000), and the item of functional obsolescence
would be incurable. If the $10,000 item had been installed originally, it would be 25%
depreciated, i.e., with a current depreciated cost of $7,500.
Table 31.9 Incurable Deficiency: Inadequate Air-Conditioning System

1. Amount of component included in cost $8,000
3. Plus
or
Examples of a Superadequacy
Some examples of superadequacies include
• Excess ceiling height
• High-end finish in a Class C office building
• A warehouse with 60% office space in a market that prefers 25% office space
A superadequacy is often difficult to cure. Consider an industrial building with 24-
ft. ceiling heights where the market norm is 18-ft. ceilings. The cost of a building with
24-ft. ceilings is $1.2 million, whereas the cost of a building with 18-ft. ceilings is $1.0
million. The subject building costs $5,000 more per year to heat and cool than compa-
rable properties with 18-ft. ceilings in the subject’s market. The extra $200,000 spent
in the original construction on the extra six feet of ceiling height adds no value to the
property and there is no reasonable cost to cure, so the superadequacy is incurable.
In this instance, the higher ceiling has no value to be recorded in Step 4. In the
calculation of functional obsolescence, the amount entered as cost if installed new is
zero. Note also that if replacement cost is used, the $200,000 cost of the superadequa-
cy will be eliminated and the measure of functional obsolescence would be only the

capitalized additional costs of ownership. The extra ceiling height costs the subject
property $5,000 more per year than the costs incurred by competitive buildings, and
analysis of income and expense data for comparable buildings yields a building
capitalization rate of 12.5% in this market. The incurable functional obsolescence is
$40,000 ($5,000/0.125). Because the item is superadequate, it does not belong in the
structure and there is no correct replacement component, so there is no entry in Step
4. The replacement cost calculation is shown in Table 31.10.
If reproduction cost is used as shown in Table 31.11, the additional $200,000 cost
of the superadequacy will not be eliminated, and $200,000 would be entered in Step 1
and the 10% depreciation already charged in Step 2.
If the extra ceiling height does earn some income in the market, the calcula-
tions would be affected by that value increment unrelated to cost. Suppose the six
feet of extra ceiling height yields an extra $7,000 in income. At the 12.5% building
capitalization rate, the value attributable to the extra ceiling height would be $56,000
($7,000/0.125), which would be accounted for in Step 4 of the calculations shown in
Table 31.12. In this case, the extra ceiling height still costs too much and creates ad-
ditional operating expenses, but it does add $56,000 in value and thus reduces the
functional obsolescence charged to that functional problem.
Now suppose that market research supports an income increase of $27,500 for
the extra 6 feet of ceiling height. At the 12.5% building capitalization rate, the 6-ft.
height advantage has a value of $220,000 ($27,500/0.125), as shown in Table 31.13. The
market norm may be 18 feet, but according to the data this market wants, and will
pay for, 24 feet.
External Obsolescence
External obsolescence is a loss in value caused by negative externalities, i.e., factors
outside a property. It is almost always incurable. External obsolescence can be temporary
or permanent. For example, value loss due to an oversupplied market may be regained
when the excess supply is absorbed and the market works its way back to equilibrium. In
contrast, the value loss due to proximity to an environmental disaster may be permanent.
External obsolescence usually has a marketwide effect and influences a whole
class of properties, rather
than just a single prop-
erty. However, external Positive Effects of External Forces
obsolescence may affect Depreciation is inherently a “loss” in property value, but the external
only one property when forces that cause external obsolescence can also cause values to go
its cause is location—e.g., up as well as down. Whether the positive effect of external forces is
proximity to negative labeled a “value enhancement,” a “positive externality,” or “negative
external obsolescence,” the positive effect of those external forces
environmental factors can be accounted for in the value indication of the cost approach in
or the absence of zoning a variety of ways.
and land use controls. In One approach is to account for the value enhancement from
fact, the causes of exter- market conditions as an external impact treated in the same manner
nal obsolescence can be as external obsolescence but as an addition rather than a deduction.
An alternative is to increase the entrepreneurial incentive in the cost
broadly characterized as approach to the level of profit that the market would currently support.
either economic obsoles- That may result in an overstated replacement cost (including entrepre-
cence or locational obso- neurial incentive). It also masks risk and could be misleading.
lescence. Most properties

Table 31.10 Incurable Superadequacy: Replacement Cost of Excess Ceiling Height
1. Replacement cost of existing item $0
3. Plus
a. cost to cure (all costs) N/A
or
4. Less cost if included in new construction or value - $0
Table 31.11 Incurable Superadequacy: Reproduction Cost of Excess Ceiling Height

1. Reproduction cost of existing item $200,000
3. Plus
or
4. Less cost if included in new construction or value - $0
Table 31.12 Incurable Superadequacy: Low Contributory Value of Excess Ceiling Height
3. Plus
or
Table 31.13 Incurable Superadequacy: High Contributory Value of Excess Ceiling Height
3. Plus
or
5. Equals depreciation from functional obsolescence $0

experience economic obsolescence from time to time as a result of the natural expan-
sion and contraction of the real estate market.3 In contrast, locational obsolescence
is caused by proximity to some detrimental influence on value such as heavy traffic,
a landfill, or other undesirable land use outside the property being appraised. For
both economic and locational obsolescence, the value-influencing factor is outside the
property and outside the control of the property owner and occupant.
External factors frequently affect the value of both the land and building compo-
nents of a property, but land is not affected by any of the forms of depreciation (i.e.,
physical deterioration, functional obsolescence, or external obsolescence). The effect
of external factors on the current land value is simply the operation of market forces
on the value of the land. Even though a loss in land value due to external factors is
not depreciation, that loss in value will still be accounted for in the final value indica-
tion of the cost approach through the estimate of site value.
Figure 31.7 illustrates various ways in which loss in value due to external influ-
ences on a property could be allocated between the land and building components.
In the figure, Column A represents the total value of the building improvements after
deducting physical deterioration and functional obsolescence ($70 per square foot
of building area) and the current land value ($30 per square foot of building area)
without yet considering the external influences on value. This would be market value
Figure 31.7 Value Loss due to External Factors Allocated between Land and Building Components
Column A Column B Column C Column D Column E

$100
20 20 20 20
Land Value ($ per sq. ft.)
70 30
50
$50 56
70
50
30 30
24
10
$0
Land value All external value Land value rises All external Proportionate
plus cost after loss attributable while building value loss value loss in
deducting physical to a building components attributable both building
deterioration and components depreciate to land value and land value
functional
obsolescence
Land Contribution
Building Contribution
Value Loss Attributable to External Influences
3. External obsolescence is sometimes called economic obsolescence because economic factors outside the control of property owners, like mortgage
interest rates and changing employment levels, can have large effects on the value of real estate. However, economic factors are only one form
of external obsolescence.

when the market is in balance or the market value of a property in a location away
from the external influence of a nuisance like a landfill. The value indication at this
point in the cost analysis would be $100 per square foot.
Column B illustrates a value loss of 20%. An appraiser has demonstrated that the
value is now $80. The land value is still unchanged at $30. Therefore, the $20 loss in
value is taken from the value of the building and is all external obsolescence.
In Column C, the value is still $80, but the land value increases from $30 to $50. In
this case, the building is worth $30, i.e., the loss to the building is $40, which is more
than the $20 loss in value to the property as a whole. This sort of loss is often an indi-
cation of a change in highest and best use, with part of the $40 loss in building value
being additional functional obsolescence. Column C could represent the change in
value of a single property over time (with the land value rising as building value
drops), or it could represent a comparison between one property with no value loss
due to external factors and a comparable property with a higher land value but some
other external issue causing depreciation of the building improvements.
Column D illustrates loss in value due exclusively to a drop in land value. In that
case, the improvements do not have external obsolescence because the effect of the
negative externality is completely accounted for in the $20 drop in land value.
Column E illustrates a 20% loss in value that is shared proportionately by both
the land and building components of the property. In this example, both the build-
ing and the land are affected in the same way, but only the 20% loss in value to the
building is external obsolescence. The 20% loss in land value is simply a loss in value
due to supply and demand for sites that compete with the land being appraised, and
in the cost approach the influence of the negative externality on the land is accounted
for in the estimate of land value.
Note that in this case the 20% loss in land value does not double-count the 20%
external obsolescence of the building because the negative externality is affecting
both the land and the building. It is important not to allocate the influence of an
externality incorrectly.
Direct comparison of similar properties with and without external obsolescence can
be the most persuasive measurement of the effect of negative externalities on value when
enough data is available for that sort of analysis. As an example of the use of paired data
analysis, consider a 12-unit apartment building located downwind of a relatively new as-
phalt batching plant. The comparable data is summarized in Table 31.14. Comparable A
is a vacant lot adjacent to the subject that is zoned for an 8-unit apartment building and
was just sold for $312,000 ($39,000 per unit). Comparable B is a vacant site on the other
side of town that is also zoned for a 12-unit apartment building and was recently sold for
$480,000 ($40,000 per unit). Comparable C is a 9-unit apartment building in the subject’s
neighborhood that was recently sold for $459,000 ($51,000 per unit). Comparable D is a
10-unit apartment building on the other side of town that was sold for $540,000 ($54,000
per unit). Using Comparables C and D, an appraiser could estimate the external obso-
lescence attributable to the property as a whole at $3,000 per unit. The subject property
would thus incur $36,000 in external obsolescence (12 units × $3,000). Comparables A
and B indicate that $12,000 of this external obsolescence ($1,000 per unit) is recognized in
the land value. The remaining $24,000, therefore, is attributable to the building.
An alternative to direct comparison of properties with and without external ob-
solescence is the capitalization of income lost due to the effect of the externality and,

Table 31.14 Direct Comparison of Properties Affected by Externality
Subject
Property Comparable A Comparable B Comparable C Comparable D
Property type Apartment Vacant site Vacant site Apartment Apartment
building zoned for zoned for building in building across
apartment use apartment use subject town
property’s
neighborhood
No. of units (or units allowed
by zoning) 12 8 12 9 10
Sale price – $312,000 $480,000 $459,000 $540,000
Price per unit – $39,000 $40,000 $51,000 $54,000
Location Downwind of Adjacent to Across town In subject Across town from
asphalt subject property from subject property’s subject property
batching plant (affected by property neighborhood
externality) (affected by
externality)
Locational effect $36,000 -$3,000 Unaffected by
(total property) ($3,000 × 12) per unit externality
Loss in land value (land) $12,000 -$1,000 Unaffected
($1,000 × 12) per unit by externality
External obsolescence $24,000
(building) ($36,000 - $12,000)
if necessary, allocating that estimate of loss in total property value between the land
and building components. This procedure is applied in two steps. First, the market
is analyzed to quantify the income loss. Next, the income loss is capitalized to obtain
the value loss affecting the property as a whole. If the income loss is anticipated to
last for the economic life of the improvements, it can be capitalized by applying ei-
ther a gross income multiplier to a gross income loss or an overall capitalization rate
to a net income loss. If the income loss is not anticipated to be long-term, it can be
estimated using discounted cash flow analysis.
An important concept in the capitalization of income loss is equilibrium rent,
which is the market-derived rental rate that would be expected in the market at
equilibrium. The equilibrium rent is compared with the actual rent affected by the
external factor in the current market, e.g., the lower rents that result from the over-
supply of competitive properties in the market. There are two methods of estimating
the equilibrium rent:
1. Base the estimate on market rent during a recent period of equilibrium adjusted
for inflation.
2. Base the estimate on depreciated replacement cost, similar to feasibility rent but
substituting depreciated replacement cost for full replacement cost.
As a simple example of capitalizing income loss, consider a 7,500-sq.-ft. strip
retail center in a market that has been hurt by a sudden, and likely long-term, popu-
lation loss and demographic shift in the neighborhood. In the property’s first five
years of operation, the average rent was around $9.00 per square foot per year, with
frictional vacancy of 10% and a net income ratio of 67%. Current rent levels have

fallen to around $6.75 per square foot. The overall capitalization rate is 7.0%. Inflation
has been nominal since the construction of the shopping center, so the equilibrium
rent for the property is $67,500 ($9.00 per square foot × 7,500 square feet = $67,500).
To calculate income loss, the net operating income at equilibrium rent and at the pre-
vailing rent are both calculated:
At Equilibrium Rent At Current Rent
Potential gross income $67,500 $50,625
Less vacancy and collection loss - $6,750 - $5,063
Effective gross income $60,750 $45,562
Net income ratio × 0.6667 × 0.6667
Net operating income $40,500 $30,375
The income loss of $10,125 ($40,500 - $30,375) is then capitalized at the overall capi-
talization rate of 7% to calculate the external obsolescence, $144,643.
As an alternative, an equilibrium rent can be calculated from depreciated re-
placement cost. Suppose the total replacement cost of the retail center is $500,000
and entrepreneurial incentive is 10% of total cost. The shopping center has $45,000 in
deferred maintenance and the remaining physical deterioration is 12.5%, based on an
effective age of 5 years and a useful life of 40 years. The shopping center has no func-
tional obsolescence, and the land value is $150,000. Equilibrium net operating income
would be calculated as follows:
Replacement cost (direct and indirect costs) $500,000
Entrepreneurial incentive + $50,000
Total replacement cost $550,000
Less deferred maintenance - $45,000
Remaining cost $505,000
Less remaining physical deterioration (12.5%) - $63,125
Cost of physically depreciated improvements $441,875
Total depreciated cost without external obsolescence $591,875
Multiplied by capitalization rate (7%) × 0.07
Equilibrium NOI $41,431
The income loss and corresponding amount of external obsolescence can then be
calculated using the new equilibrium net operating income.
Equilibrium NOI $41,431
Less actual NOI - $30,375
Income loss $11,056
Capitalized at 7% ÷ 0.07
External obsolescence $157,943
Finally, the indicated value by the cost approach can be calculated by adjusting the
previously calculated depreciated cost for all sources of depreciation other than exter-
nal obsolescence.
Total depreciated cost without external obsolescence $591,875
Less external obsolescence - $157,943

Note that the two estimates of obsolescence, $144,643 and $157,943, are complete-
ly attributed to the improvements. The land value is assume to be the same in both
the actual net operating income and the equilibrium net operating income calcula-
tions. There is no loss allocated to the land. (If the land value is concluded to be lower
due to the external issue, then the amount of external obsolescence attributed to the
improvements would be, for example, the $157,943 amount less the amount of the re-
duction in the land value.) Also note that when the equilibrium net operating income
is calculated from cost, the value indicated by the cost approach will be the same as
the value indicated by the income capitalization approach:
Actual NOI $30,375
Capitalized at 7% ÷ 0.07
Indicated value by income capitalization approach $433,929
In this case, the $3 difference is a result of rounding. Otherwise the value indications
would be identical.
If the income loss of the retail center is the result of a temporary oversupply of
competitive properties in the market rather than a long-term phenomenon, the value
loss should be calculated using discounted cash flow analysis rather than direct capi-
talization. In the discounted cash flow analysis, the cash flow period would be the
expected term of the income loss rather than the projection period of ownership. The
present value of the income loss would be the value loss due to the externality. If a
direct capitalization method is used for such a short-term loss, the capitalization rate
would need to be higher than the overall capitalization rate for the property because
of the limited term of the condition causing the loss. However, it may be difficult to
support the capitalization rate that would be applicable to a short-term condition.

Reconciling Value Indications 32
In the valuation process, more than one approach to value is usually applied, and
each approach typically provides a different indication of value. Reconciliation is the
process in which different indications of value are converted into a value conclusion.
If two or more approaches are used, appraisers must reconcile the value indications.
Moreover, several value indications may be derived in a single approach. In the sales
comparison approach, for example, the analysis of each comparable sale produces
an adjusted sale price, which is an indication of value for the subject property. The
various units of comparison applied to sales may also produce different value
indications. For example, apartment properties may be analyzed in terms of price
per unit or price per room, and office buildings in terms of price per square foot of
gross building area or price per square foot of rentable area. In an analysis of income,
different indications of value can result from applying income multipliers to specific
types of income, directly capitalizing net income, and discounting cash flows.
Appraisers resolve multiple value indications derived within a single approach
as part of the application of that approach. After resolving multiple value indica-
tions within a single approach, an appraiser applies the same process to the value
indications of multiple approaches, providing the client with clear analyses of why
the results of one (or more) of the approaches to value is given more weight than the
results of the others.
Resolving the differences among various value indications is called reconciliation.
Although the result of the final reconciliation process is usually the ultimate value
conclusion, the reconciliation analysis may indicate that more research is needed or
that new analyses must be performed to resolve conflicts or answer questions. Thus,
reconciliation provides an integral quality control assessment of the valuation pro-
cess prior to the final opinion of value and also helps identify key factors that must
be clearly cited and explained, or explained further, in the appraisal report.
The final value opinion is not the average of the different value indications
derived. No mechanical formula is used to select one indication of value over the oth-
ers. The strengths and weaknesses of each of the approaches used, and the quantity
and quality of the data analyzed, must be considered and addressed in an appraisal
report, and an appraiser must explain why one approach may have been relied upon
more than another in a particular assignment. Final reconciliation relies on the proper
application of appraisal techniques and the appraiser’s judgment. Figure 32.1 illus-
trates the types of questions that appraisers ask when reconciling value indications
within the approaches to value.
In summary, reconciliation has a defined purpose and is an essential step in the
valuation process, but it also provides appraisers with an opportunity to smooth out
any apparent inconsistencies. For example, reconciliation is the stage of the valuation
process in which an appraiser could explain once again that the sale across the street
from the subject property, which appeared comparable, was not considered because
it was not an arm’s-length transaction. Or, as another example, in final reconcilia-
tion an appraiser could explain that even though the client made the application of
the cost approach an assignment condition, the results of that approach were not
given any weight because the appraiser believed that the approach did not provide a
credible value indication. Valuation standards such as USPAP require that the value
conclusion be compared with any recent sale of the subject property, and this com-
parison can also be included in the reconciliation.
Experienced appraisers know how to write a report so that readers will know the
conclusion before they see it. In other words, through a logical progression of ideas,
the strengths and weaknesses of the techniques applied are described and the reasons
for weighting some approaches more than others are expressed clearly. Reconciliation
is an important part of appraisal and an invaluable part of the reporting process.
Final Reconciliation
In the final reconciliation, an appraiser reconsiders the entire appraisal, making sure
that the data available and the analytical techniques and logic applied have led to
consistent judgments. The appraiser checks the data to ensure that it is verified, ap-
plicable to the assignment, and sufficient to support a credible opinion of value. The
value definition, the identified property rights, and the qualifying conditions im-
posed are carefully reconsidered to make sure that the procedures used in the analy-
sis specifically address each of these items. The appraiser examines the differences in
the conclusions derived from the various approaches, applies tests of reasonableness
to these primary conclusions, and resolves any inconsistencies.
At this stage of the valuation process, appraisers ask a variety of questions:
• Is the same physical condition assumed in making adjustments to comparable
rents, expenses, and sale prices in the income capitalization and sales comparison
approaches?
• Are the results of all the approaches consistent with the appraiser’s conclusion of
highest and best use?
• Do the value indications derived from the approaches applied reflect the same
property rights and asset type? For example, a value indication derived from the
income capitalization approach that is higher than an indication based on the
cost approach may or may not include a non-realty value component.
• Are the property rights appraised consistent throughout the appraisal? For ex-
ample, if the subject property is the leased fee interest and the income capitaliza-

Figure 32.1 Questions Asked in Reconciling Value Indications Within the Approaches to Value
Regarding identification of the problem and the subject property:
• Is the building area in the description of improvements generally consistent in all the approaches used in the valuation?*
• Are the property features listed in the description of improvements the same in all the approaches to value?
• Is the effective date of appraisal consistent with the data presented?
• Have the highest and best uses of the land as thought vacant and the property as improved been properly analyzed?
Regarding the sales comparison approach:
• Is the approach relevant to the appraisal assignment?
• Was adequate market research conducted to identify sales that are relevant to the valuation problem?
• Are the sales sufficiently verified and relevant to the effective date?
• Would market participants consider them to be reasonably comparable?
• Are there prior sales of the subject property that need to be analyzed?
• Is there adequate market support for the adjustments that were made?
• Were those factors that could not be supported by quantitative adjustment dealt with adequately using qualitative analysis in
the reconciliation?
• Are the adjusted sale or unit prices within the range exhibited in the market?
• Are the conclusions of the approach consistent with the conclusions reached in the other approaches or, if not, can inconsisten-
cies be explained?
Regarding land valuation:
• If a sales comparison analysis was performed, was adequate market research performed to identify sales that are relevant to
the valuation problem?
• Are the sales sufficiently verified and relevant to the effective date?
• Would market participants consider them to be reasonably comparable?
• Are there prior sales of the subject property that need to be analyzed?
• Is there adequate market support for the adjustments that were made?
• Were those factors that could not be supported by quantitative adjustment dealt with adequately using qualitative analysis in
the reconciliation?
• Are the adjusted sale or unit prices within the range exhibited in the market?
Regarding the cost approach:
• Is the land value well supported?
• Was replacement or reproduction cost estimated?
• Is the effective age of the property used in the cost approach consistent with the physical condition reported?
• Are the cost estimates reliable and market-based?
• Do the cost estimates account for all of the costs?
• Are the sales used to extract depreciation from the market reliable?
• What method was used to support depreciation estimates?
• Were physical, functional, and external depreciation estimated accurately?
cies be explained?
Regarding the income capitalization approach:
• Is there an adequate number of rental comparables?
• Are the rental properties comparable?
• Is there market support for the adjustments that were made?
• Is historical expense information available? If so, how meaningful is it?
• Are the expense projections in line with market estimates?
• Is there market support for the capitalization or discount rate?
• Does the method of capitalizing income reflect market practices?
cies be explained?
* Note that the building area considered may not be the same in each approach. For instance, gross building area may be used in the cost approach
for an office building, but rentable area is typically applied in the income capitalization and sales comparison approaches.

tion approach is based on leased fee income, do the values indicated by the sales
comparison and cost approaches also reflect the value of the leased fee interest?
• Is the market area analysis consistent in the sales comparison, income capitaliza-
tion, and cost approaches? For example, if values are increasing and there is good
demand as indicated in the neighborhood description section of the appraisal
report, is that description consistent with the market conditions illustrated in the
application of the approaches to value?
In final reconciliation, all mathematical calculations should be checked,
preferably by someone other than the person who performed them originally.
Significant errors can lead to incorrect value indications, and even minor errors can
diminish a client’s confidence in an appraisal. Finally, the logic employed throughout
the valuation process should be scrutinized, and appraisers should ask these
additional questions:
• Do the approaches and methods applied consider all the available data and sys-
tematically lead to meaningful conclusions that relate directly to the intended use
of the appraisal?
• Does the appraisal provide the information required to solve the client’s prob-
lem? For example, if the client wants to establish a depreciation basis to compute
federal income tax, does the appraisal allocate separate values to the improve-
ments and the land? A client who contemplates remodeling will want informa-
tion on the costs and benefits of this plan. If the client is considering whether to
accept an offer to purchase, the appraiser may be asked to analyze the terms of
the proposed contract.
Final Opinion of Value

In an appraisal report, the final opinion of value may be stated as a single figure, as a
range of values, or in relation to a benchmark amount (e.g., “not more than” or “not
less than” a certain amount). A reconciliation section of a report consisting of boiler-
plate and stock comments does not often present useful information. A discussion of
the data analyzed and its application to the subject, how the approaches apply to the
subject, and other relevant information is essential to a meaningful reconciliation.
Most often, an opinion of value is reported as a single dollar amount, i.e., a point
value at a particular point in time. Because of legal or other requirements, most cli-
ents require a point estimate of value.
A point estimate should be rounded to reflect the degree of precision that an ap-
praiser can associate with the particular opinion of value. Often the manner in which
a figure is rounded is a matter of convention—e.g., to two or three significant digits.
For example, if the final value estimate is a six-digit number, the figure will likely be
rounded to the nearest ten thousand or hundred thousand dollars. If it is a seven-
digit number, it will likely be rounded to the nearest hundred thousand dollars.
Although appraisers typically do not provide a confidence rating with a value
opinion, the reconciliation section of the appraisal report is a good place to convey the
concept. If, for example, there were very few recent market transaction, or there has
been a recent event that may have suddenly impacted market conditions, the apprais-
al report should convey that there is some risk inherent in the final value conclusion.
The reduced level of confidence is not the fault of the appraiser. Rather, it is the result

of applying an analytical framework to an imperfect market. The appraiser is reflect-
ing the anticipations of market participants and market participants may be dealing
with uncertainty. In another situation, there may be plenty of sales to use in the sales
comparison approach, and each sale may require very little adjustment. In this case,
the appraiser will be able to convey a high level of confidence in the value opinion.

The Appraisal Report 33
The conclusions reached by appraisers in valuation analysis are communicated to the

users of appraisals in appraisal reports, which may be written or oral. Most appraisal
clients request written reports, and some have specific formats that they prefer. Re-
gardless of whether an appraisal report is written or oral, it leads the reader from the
identification of the appraisal problem through the relevant descriptive and support-
ing data to the analysis of that data and then to the appraiser’s conclusion.
The length, type, and content of appraisal reports are dictated by the intended use,
the type of value, ownership interest appraised, the nature and complexity of the prob-
lem to be solved, and, most importantly, the information needs of the intended users.
Reporting formats for residential and commercial appraisals vary. As long as the
reporting requirements are met, valuers have a lot of flexibility in how they commu-
nicate their analyses and conclusions.
Valuation Standards for Appraisal Reports

Valuation standards address the required content of a written or oral appraisal
report. Standard C of the Appraisal Institute Standards of Valuation Practice covers
appraisal reports as well as review reports. The International Valuation Standards ad-
dress valuation reporting in IVS 103. For appraisals subject to the Uniform Standards
of Professional Appraisal Practice, Standard 2 sets forth the minimum requirements
for reporting an appraisal of real property. Standard 4 of USPAP addresses review
reports, which are covered in depth in the next chapter of this text. SVP, IVS, and
USPAP all require that the appraisal results be communicated clearly, accurately, and
in a manner that is not misleading, and that the report contain sufficient information
to enable all intended users to understand the report properly.
The Uniform Appraisal Standards for Federal Land Acquisitions (UASFLA)
establish standards for appraisal reporting content and documentation in appraisal
assignments involving real property being acquired by the federal government. The
UASFLA document summarizes the reporting requirements and includes a report
documentation checklist in an appendix.
Appraisers may use any number of forms for reporting but should be wary of
appraisal report forms that do not call for all of the information required under stan-
dards. Some appraisal report forms need to be supplemented with essential infor-
mation for understanding the appraisal relating to the scope of work, intended use,
intended user, and highest and best use. It is incumbent on appraisers to understand
whether the form or format being used allows for compliance with the reporting
requirements of the applicable standards.
Oral Reports
An appraiser may communicate assignment results in an oral report when the circum-
stances or the needs of the client and other intended users do not require or warrant
a written report. Oral reports may be communicated
to the client and other intended users in person, by
Components of a Workfile telephone, in a conference call or videoconference, or by
Required by USPAP other means. Expert testimony presented in a deposi-
A workfile must include a tion or in court in which a value opinion is given is
true copy of the written ap-
praisal report(s). A workfile an oral appraisal report, unless the testifying expert
for an oral appraisal report previously transmitted a written report or summary
must include a summary of of an oral report to the client. In USPAP, the reporting
the oral report as well as a requirements for oral reports are set forth in Standards
signed and dated certifica- Rule 2-4, which states that, to the extent that is both
tion. In USPAP, workfile is
defined as “data, informa- possible and appropriate, an oral report must address
tion, and documentation the substantive matters set forth for a written appraisal
necessary to support the report in Standards Rule 2-2. Oral reports must include
appraiser’s opinions and the underlying bases of the appraisal, especially any
conclusions and to show extraordinary assumptions or hypothetical conditions
compliance with USPAP.”
used. After communicating an oral report, an appraiser
must keep a summary of the oral report and all notes
and data relevant to the assignment in the workfile so
that, if asked at a later date (i.e., any time during the re-
quired record retention period), the appraiser could produce a report that would meet
the minimum requirements for a written appraisal report under Standards Rule 2-2(a).
The organization and composition of an appraiser’s workfile may vary so long as
the file contents are retrievable by the appraiser during the required record retention
period. The workfile can reference information that is located elsewhere—e.g., stored
electronically on a computer, on a website, in another file, or at some other location.
Written Appraisal Reports

Written appraisal reports may be form reports or narrative reports. Usually an ap-
praisal report is presented in the format requested by the client, i.e., either a form
report or a narrative report depending on the intended use of the appraisal. Even if
a client asks for a report that does not include detailed information (e.g., a restricted
appraisal report as defined in USPAP), an appraiser must undertake the analysis
required by the assignment as established by the scope of work. In such a case, the

appraiser keeps all necessary material, research data, and documents used to prepare
the appraisal in the workfile. Although appraisers may never need to provide written
substantiation for value opinions that are submitted in abbreviated form, they may
be asked to explain or defend their opinions at a later time.
Form Appraisal Reports

Form reports are often needed by financial institutions, insurance companies, and
government agencies. For example when Fannie Mae and Freddie Mac introduced
the Uniform Residential Appraisal Report (URAR), it was the first form to be ad-
opted by all the major governmental and quasi-governmental agencies (Fannie Mae,
Freddie Mac, the Department of Housing and Urban Development, the Department
of Veterans Affairs, the Department of Agriculture, and the Federal Home Adminis-
tration) involved in residential mortgage lending activities. Since the URAR was last
revised in 2005, many more forms have been developed by different institutions to
cover a variety of appraisal reporting scenarios:
• Uniform Commercial/Industrial Appraisal Report
• Exterior-Only Inspection Residential Appraisal Report
• Individual Condominium Unit Appraisal Report
• Small Residential Income Property Appraisal Report
• ERC Summary Appraisal Report
• The Appraisal Institute’s Residential Green and Energy Efficient Addendum and
various AI Reports forms1
Form reports are required for the purchase and sale of most homes and existing
mortgages on residential properties in the secondary mortgage market created by
government agencies and private organizations. Because these entities review many
appraisal reports, using a standard report form is both efficient and convenient.
When a form is used, the parties responsible for reviewing the appraisal report know
exactly where to find each category or item of data in the report. By completing the
appraisal report on a form, an appraiser ensures that no item required by the review-
er is overlooked. Note that the space allowed on some common report forms may not
be sufficient to accommodate the supporting data or reasoning necessary for credible
assignment results. Appraisers will likely need to provide additional information in
an addendum or supplement to the form.
Some form reports do not address all of the information required by valuation
standards. These forms may be used only if they are augmented with supplemental
information so that they meet the applicable reporting standards. In addition, most
forms in use do not contain the certification statements required by the Certification
Standard of the Appraisal Institute. Members, candidates, and practicing affiliates of
the Appraisal Institute must therefore attach supplemental material when they use
these forms. (Certification statements are discussed in a later section of this chapter.)
Appraisers who use form reports must be careful. The certification included
in available software may be out of date or not compliant with Appraisal Institute
1. For an in-depth discussion of appraisal form reports, see the following Appraisal Institute guidebooks by Mark Rattermann: Using the Individual
Condominium Unit Appraisal Report Forms: Fannie Mae Form 1073 and Exterior-Only Form 1075 (2006); Using Residential Appraisal Report
Forms: URAR, Form 2055, and the Market Conditions Form, 2nd ed. (2009); and Using the Small Residential Income Property Appraisal Report:
Fannie Mae Form 1025/Freddie Mac Form 72 (2006).

requirements or with applicable state appraisal law. With the exception of the Ap-
praisal Institute’s AI Reports forms, the certification provided in a form report is not
compliant with the Code of Professional Ethics and Standards of Professional Prac-
tice of the Appraisal Institute. Additional statements are required to be compliant.
It does not matter where these additional statements go in the report. They can be
added to the certification page or presented in another logical place.
Guide Note 3 in the Guide Notes to the Standards of Professional Practice of the
Appraisal Institute addresses the use of form reports in the appraisal of residential
property. Forms are increasingly being used for appraisals of both residential and
nonresidential properties, e.g., apartment, commercial, and industrial properties.
Appraisers must be careful to ensure that a report form does not dictate the scope
of work to be applied in the valuation process. The methods and techniques em-
ployed in a valuation are determined by the nature of the specific appraisal problem,
not by the type of report. If a report form does not provide for adequate presentation
and discussion of all the analysis and data that an appraiser believes to be pertinent,
that information must be added as a supplement.
For example, the space provided in the Uniform Residential Appraisal Report
(URAR) for reporting the highest and best use of the property is limited. Because the
creators and users of the form—e.g., Fannie Mae, Freddie Mac—only intend to make
loans on single-unit residential properties, they can meet their informational needs
with a simple yes-no question. If the answer is not yes—i.e., the current use is not
the highest and best use—those entities will not make the loan because they are only
lending on properties that are residential and are expected to continue as residential
property for the life of the loan.
An appraiser’s perspective is different, however, and the determination of high-
est and best use is central to the valuation process. The highest and best use section
of a form report frequently must be supplemented. It is not sufficient to simply check
the box to indicate that the highest and best use is “as improved.” Some additional
detail is required, even when the existing improvements do represent the highest and
best use. USPAP’s Standards Rule 2-2(a) includes language relating to highest and
best use, specifying that an appraiser “summarize the support and rationale for that
opinion.” A brief statement can satisfy the requirements of the standards rule, but an
appraiser must provide more than a checked box.
In 2011 and 2012, the government-sponsored entities (GSEs) active in the second-
ary mortgage market in the United States and the US Department of Housing and
Urban Development developed the Uniform Appraisal Dataset (UAD) to be used
with four of the Fannie Mae/Freddie Mac residential forms (1004/70, 2055, 1073/465,
and 1075/466). The key element of the UAD is the development of common appraisal
data definitions to be used in UAD-compliant appraisal forms. Although the apprais-
al forms were not changed at that time, sections of the form inputs later were changed
to incorporate the new UAD language. In other words, the forms did not change, but
how they are completed did. The inputs are now standardized to enable digital rec-
ognition. The GSEs now require this new language to be used in appraisal reports for
single-unit dwellings and condominiums. Standardization has been imposed on the
two- to four-unit form report as well. Some of the fields are required, while others are
considered instruction fields. Many of the requirements are only directions as to how
to format a date or how many decimal places to use in a given field.

The change to UAD language has allowed national mortgage market participants
to use computer programs to compare and contrast the inputs from a single appraiser
with that individual’s prior appraisals and with appraisal reports prepared by other
appraisers. As a result, if an appraiser reports that a comparable sale included 1.2
acres but another appraiser reported that the same property has 2.1 acres, a query can
be sent to the second appraiser to confirm the data.
The Uniform Residential Appraisal Report (URAR) and AI Reports Forms

Typically, addenda to the URAR form are needed to meet USPAP’s reporting require-
ments (such as the inclusion of an estimate of exposure time). Moreover, members,
candidates, and practicing affiliates of the Appraisal Institute will need to add the
Appraisal Institute’s certification statements. Supplementation will be needed to
address the reporting requirements not covered by the form, in addition to a current
certification as required by Standards Rule 2-3 of USPAP.
The revised URAR form is specifically used for mortgage lending purposes. (Page
1 of the URAR form is shown in Figure 33.1.) In 2005, the Appraisal Institute designed
appraisal report forms for use in non-mortgage lending situations. Use of the Apprais-
al Institute’s AI Reports forms is highly recommended when an appraisal does not
need to meet Fannie Mae, Freddie Mac, FHA, or VA requirements. If an assignment is
for a lender who is not concerned with these entities, use of the URAR is not required.
For a nonlending client, the URAR is not appropriate. The form was designed specifi-
cally to meet lender needs. The scope of work is tailored to mortgage lending and so
are the assumptions and limited conditions and the definition of value.
AI Reports forms are available to all appraisers at www.appraisal institute.org/
professional-practice/professional-practice-documents/ai-reports. (Page 1 of the AI
Reports Residential form is shown in Figure 33.2.) The forms are designed around the
assignment parameters and the scope of work appropriate for the assignment. The
scope of work best defines the needs of the client and intended user of the report and
dictates what factors an appraiser considered during the valuation process.
Narrative Appraisal Reports

In a narrative appraisal report, the most detailed and customizable format for report-
ing appraisal conclusions, an appraiser provides support and rationale for his or her
opinions and conclusions to convince the reader of the soundness of the final opinion
of value. In preparing a narrative appraisal report, descriptive sections should be
separate from analysis and interpretation. Factual and descriptive data is usually pre-
sented in early sections of the report so that subsequent analysis and interpretation
may refer to these facts and indicate how they influence the final opinion of value.
Unnecessary duplication should be avoided.The presentation of data may depend on
the nature and complexity of the valuation problem.
The research presented in a well-prepared appraisal report can be detailed, and the
report should exhibit logical organization and sound reasoning. These basic attributes
are enhanced by good composition, a fluid writing style, and clear expression. The use
of technical jargon, legalese, and slang should be avoided. To communicate with the
reader effectively, an appraiser should set forth the contents of the report as succinctly
as possible. Figure 33.3 lists some principles of effective appraisal report writing.
An appraiser might not be present when the report is reviewed or examined, so
the report is the appraiser’s representative. A well-written report displays the ap-

Figure 33.1 Page One of the Uniform Residential Appraisal Report Form

Figure 33.2 Page One of AI Reports Form 100.05

Figure 33.3 Preparing a Narrative Appraisal Report
1. Clarify the organization of the report.
2. Reveal the organization visually (e.g., using the six-step market analysis process as an outline for the report).
3. Use standard publishing techniques to increase readability.
• Typeface
• Size
• Line length
• Justification
• Creating emphasis
4. Graphics are powerful reporting tools.
5. Calculations need to be surrounded by white space.
6. Use tables and spreadsheets effectively.
7. Pie charts, line graphs, and bar graphs reveal relationships and trends.
8. Place graphics and exhibits where they communicate most effectively.
9. Label and number exhibits for easy reference.
Source: Alan Blankenship, The Appraisal Writing Handbook (Chicago: Appraisal Institute, 1998), Chapter 2.
praiser’s professional competence. The following suggestions may help appraisers

make a good impression:
• If a “hard copy” report is produced, the paper, cover, and binding of the report
should be of good quality.
• The size and style of the type used should be readable. Graphics such as photo-
graphs, charts, and graphs should be carefully prepared, and white space should
be used judiciously to highlight the important information. The style of headings
and subheadings should be appropriate to the subject matter.
• Ideally, illustrations should be integrated within the text and presented where
they are discussed. For example, a photograph of the subject property can be
placed near the identification of the property. A neighborhood map could be
included with the neighborhood description to show the location of the subject
property. Illustrations that are not directly related to the narrative can be placed
in the addenda.
• The contents of the report should be presented in clearly labeled sections that are
identified in the table of contents.
General Outline
Narrative appraisal reports will vary in content and organization, depending on the
needs of the client and other intended users, but they all contain certain elements. Es-
sentially, a narrative appraisal report follows the order of steps in the valuation process.
Most narrative appraisal reports have four major parts. The contents of each section
may be formally divided with subheadings or presented in a continuous narrative. In
either case, the major divisions of the report should be identified with individual head-
ings. The four basic parts of a report are (1) the introduction, (2) identification of the
appraisal problem and scope of work, (3) the presentation of data, and (4) the analysis
of data and conclusions. Many reports have a fifth section, the addenda, that includes
supplemental information and illustrative material that would interrupt the text.

The organization of narrative reports varies, but the outline in Figure 33.4 can
be used as a general guide. The arrangement of items in this outline is flexible and
can be adapted to almost any appraisal assignment and any type of real property. In
practice, this outline would be adapted to the particular requirements of the assign-
Figure 33.4 General Outline of a Narrative Appraisal Report

Part One—Introduction
Title page
Letter of transmittal
Table of contents
Certification
Summary of conclusions
Part Two—Identification of the Appraisal Problem and Scope of Work
Identification of the client and other intended users
Statement of intended use
Identification of the subject real estate and description of the property rights appraised
Type and definition of value and source of definition
Effective date of opinion of value
Extraordinary assumptions, hypothetical conditions, and jurisdictional exceptions
General assumptions and limiting conditions
Scope of work
Part Three—Presentation of Data
Legal description
Identification of any personal property or other items that are not real property
Property history, including prior sales and current offers or listings
Market area, city, neighborhood, and location data
Land description
Improvement description
Taxes and assessment data
Part Four—Analysis of Data and Conclusions
Market analysis
Highest and best use analysis
Land or site value
Cost approach
Sales comparison approach
Income capitalization approach
Reconciliation and final opinion of value
Estimate of exposure time
Qualifications of the appraiser
Addenda
Photographs
Detailed legal description, if not included in the presentation of data
Detailed statistical data
Leases or lease summaries
Other appropriate information
Secondary exhibits

ment and to suit the personal preferences of an appraiser and, more importantly, the
client and other intended users.
Part One—Introduction
Title Page. The title page lists the real property identification, the date of value, the
name and address of the appraiser, and the name and address of the client.
Letter of Transmittal. Figure 33.5 illustrates a typical format for a letter of transmittal. The
letter of transmittal formally presents the appraisal report to the client. It should be
drafted in proper business style and be as brief as the character and nature of the as-
signment permit. A suitable letter of transmittal may include the following elements:
• Date of letter and salutation
• Street address of the property and a brief description, if necessary
• Statement identifying the interest in the property being appraised
• Statement that the property inspection and all necessary investigation and analy-
ses were made by the appraiser
Figure 33.5 Sample Letter of Transmittal

June 1, 2019
<Client name>
<Client organization>
<Street address>
<City, state, and ZIP>
RE: Appraisal of
1585 Northwestern Highway
Springfield, OR 29055
Dear <Client>:
In accordance with your request, I have appraised the above-referenced property. The attached report, containing XX
pages, provides the data and reasoning used in reaching my opinions and conclusions.
The purpose of the appraisal is to develop an opinion of the market value of the fee simple estate of the property as
of May 1, 2019. The intended use of the report is to assist in a permanent lending decision. My client, <Client>, is
the sole intended user of this report. No other use or users are intended.
The subject real estate consists of a 30,000-sq.-ft. distribution warehouse facility located on a 3-acre site. In addition
to the main building, the property includes paved parking for 60 vehicles, a loading dock area, and miscellaneous
landscaping and signage.
A significant factor in this appraisal is that the region was affected by Hurricane A, a category 5 hurricane, in August
20XX. Please refer to the discussion of this event and its effect on local market conditions on p. XX.
My opinions and conclusions are based on the scope of work described in this report and qualified by the definitions,
assumptions, limiting conditions, and certifications set forth.
Based on my analysis, my opinion of the market value of the subject property, as set forth, documented, and qualified
in the attached report under conditions prevailing on May 1, 2019, was:
ONE MILLION FIVE HUNDRED FIFTY THOUSAND DOLLARS
$1,550,000
<Signature>
<State certificate or license no. (if appropriate)>

• Reference that the letter is accompanied by an appraisal report of a specified
number of pages and identification of the appraisal problem and report format
• Type of value developed in the appraisal report
• Effective date of the appraisal
• Opinion of value
• Any extraordinary assumptions and hypothetical conditions
• Appraiser’s signature
Table of Contents. The various sections of the report are customarily listed in order in
the table of contents. The major divisions of the report and any subheadings used in
the report should be shown here.
Certification. The certification usually follows the final opinion of value and must be
signed by the appraiser. The certification states that the appraiser has personally
conducted the appraisal in an unbiased, objective manner in accordance with profes-
sional standards.
Note that the proper term is certification, not certificate, certificate of value, or cer-
tification of value. The certification statements relate to the entire assignment and the
manner in which it was completed, not just the value conclusion.
Whether the certification is included as part of the introduction or presented on a
separate, signed page, certification is important because it establishes an appraiser’s
role, thereby protecting both the appraiser’s integrity and the validity of the apprais-
al. An appraiser who signs any part of the report, including a letter of transmittal,
must also provide a signed certification.
Certification requirements may change, so an appraiser must provide a certifica-
tion that is applicable on the report date. To assist appraisers, the Appraisal Institute
provides sample certification statements for written appraisal reports and written ap-
praisal review reports on its website. These documents, which include both the state-
ments required by USPAP and the statements required by the Appraisal Institute, can
be downloaded and copied directly into appraisal reports.
The USPAP certification does not have to be exactly the same as the language
used in Standards Rule 2-3, but it must be similar in content. (In contrast, the Ap-
praisal Institute’s certification statements must be reproduced verbatim.) Appraisers
must be careful not to deviate from the intent of the language if they do not use the
USPAP certification language exactly. Additions relevant to the assignment are per-
mitted. The value conclusion need not be included in the certification. The certifica-
tion need not be dated (except in the case of the certification retained in the workfile
for an oral report).
The certification is an important part of an appraisal report. Only an appraiser
can make such a statement. The report reader should know that the appraiser is com-
mitted to doing good work, which is confirmed by the certification statements.
Summary of Conclusions. When an appraisal report is long and complex, a summary
of the major points and conclusions in the report may be useful. Such a statement,
which is sometimes called an executive summary, is convenient for readers of the
report, and that statement allows an appraiser to stress the major points considered
in reaching the final opinion of value. It is critical that the information provided in
the summary not conflict with the information in the body of the report. Although all

Certification Standard of the Appraisal Institute
The Certification Standard of the Appraisal Institute requires members, candidates, and practicing affiliates of
the Appraisal Institute to include the following statements:
• The reported analyses, opinions, and conclusions were developed, and this report has been prepared, in
conformity with the requirements of the Code of Professional Ethics and Standards of Professional Prac-
tice of the Appraisal Institute.
• The use of this report is subject to the requirements of the Appraisal Institute relating to review by its duly
authorized representatives.
Also, one of the following statements must be included in any report prepared by a designated member of
the Appraisal Institute (according to Certification Standard Rules 1-3):
Either
As of the date of this report, I (or Designated Member’s name or Designated Members’ names)
have/has completed the continuing education program for Designated Members of the Ap-
praisal Institute.
or
As of the date of this report, I (or Designated Member’s name or Designated Members’ names)
have not/has not completed the continuing education program for Designated Members of the
Appraisal Institute.
Candidates of the Appraisal Institute must include one of the following statements in any report prepared
by those individuals (according to Certification Standard Rules 1-4 and 1-5):
Either
As of the date of this report, I (or name or names) have/has completed the Standards and Ethics
Education Requirements for Candidates of the Appraisal Institute.
or
As of the date of this report, I (or name or names) have not/has not completed the Standards
and Ethics Education Requirements for Candidates of the Appraisal Institute.
Practicing Affiliates of the Appraisal Institute must include one of the following statements in any report
prepared by those individuals (according to Certification Standard Rules 1-4 and 1-5):
Either
As of the date of this report, I (or name or names) have/has completed the Standards and Ethics
Education Requirements for Practicing Affiliates of the Appraisal Institute.
or
As of the date of this report, I (or name or names) have not/has not completed the Standards
and Ethics Education Requirements for Practicing Affiliates of the Appraisal Institute.
Once a practicing affiliate who is not an Appraisal Institute designated member has completed at least one
five-year continuing education cycle in which he or she was required to fulfill the Points and Standards and
Ethics Education Requirements, the practicing affiliate must include one of the following statements in the
certifications of his or her written reports (according to Certification Standard Rule 1-5):
Either
As of the date of this report, I (or name or names) have/has completed the continuing education
program for Practicing Affiliates of the Appraisal Institute
or
As of the date of this report, I (or name or names) have not/has not completed the continuing
education program for Practicing Affiliates of the Appraisal Institute.

of the items listed below do not apply to every appraisal assignment, the following
information is frequently included in a summary:
• Brief identification of the property (i.e., the interest appraised and real estate)
• Any extraordinary assumptions or hypothetical conditions
• Determinations of the highest and best use of the land as though vacant and of
the property as improved
• Distinguishing property characteristics, such as deferred maintenance or unique
features that affect value
• Land value opinion
• Value indication from the cost approach
• Value indication from the sales comparison approach
• Value indication from the income capitalization approach
• Final opinion of defined value
Figure 33.6 illustrates one possible format for a summary of conclusions included in
an appraisal report.
Figure 33.6 Sample Summary of Facts and Conclusions

Property type: 30,000-sq.-ft. distribution warehouse facility
Location: 1585 Northwestern Highway
Springfield, OR 29055
Date of value opinion: May 1, 2019
Property rights appraised: Fee simple estate
Site: A three-acre interior site that is fully improved and appears to conform to all ap-
plicable ordinances
Improvements: A two-year-old masonry warehouse facility that contains 30,000 square feet of
gross area. The finished office area of the building consists of 3,000 square feet,
or 10%, which is typical for this type of building in this area. There is paved park-
ing for 60 vehicles, miscellaneous landscaping, and one pole sign.
Client: <Client>
Intended use: To provide a value opinion and documentation that will assist in a permanent
lending decision
Intended user(s): <Client>
Zoning: I-1 Industrial
Highest and best use:
As though vacant A masonry distribution facility of 25,000 to 30,000 square feet with 3% to 5%
office finish
As improved Current use as a distribution warehouse facility is optimum use
Site value: $350,000
Cost approach: $1,610,000
Sales comparison approach: $1,525,000
Income capitalization approach: $1,565,000
Final value opinion: $1,550,000

Part Two—Identification of the Appraisal Problem and Scope of Work
Identification of the Client and Other Intended Users. An appraiser who writes a report is
writing to his or her client and other intended users. They are the audience for the
analysis and conclusions. Valuation standards require that the report contain suffi-
cient information to enable the intended users to understand the report properly. To
ensure that the report contains sufficient information, an appraiser must first know
who the intended users are.
It is a misconception that the “addressee” named in the report is necessarily the
client. Although appraisers often assume it is understood that the addressee is the cli-
ent, this may or may not be the case. The report must specifically identify the client,
whether the client is an individual or an entity.
The client is always considered an intended user but is not necessarily the only
intended user. Appraisers are responsible for reporting conclusions and analyses in a
manner that is clear and understandable to all intended users identified at the time of
the assignment.
Statement of Intended Use. The report must include a clear statement of how the ap-
praiser intends the appraisal to be used, which should align with the client’s reason
for requesting it.
Identification of Subject Property. A complete legal description is used to identify the sub-
ject property. Depending on the nature of the subject property, an appraiser may need
to provide more or less detail to identify the subject property clearly. For example, a
parcel of raw land may need to be identified by a detailed metes and bounds descrip-
tion, or an assessor’s identifying parcel number, whereas an existing home might be
identified simply by a street address. Maps and surveys can be used if the sources are
adequate and clear.
Identification of Property Rights Appraised. In identifying the subject property, an ap-
praiser must state and describe all the rights or interests being valued. If helpful to
the intended users, definitions of the rights or interests should be included. More
discussion is warranted in appraisals of partial interests in property or limited rights
such as surface or mineral rights. Other encumbrances such as easements, mortgages,
and special occupancy or use requirements should also be identified and explained in
relation to the defined value to be developed. Personal property and other items that
are not real property should be identified.
Type and Definition of Value. The definition of the type of value being appraised is in-
cluded in the report to eliminate any confusion in the mind of the intended user (or
users) or other readers of the report. (Definitions of various types of value are cited in
Chapter 6.) USPAP also requires that the source of the value definition be cited.
Effective Date. An appraisal assignment may call for one or more of the following:
• A current value opinion
• A value opinion as of a retrospective date
• A value opinion as of a prospective date
It is essential to report the date as of which the value conclusion is applicable. Com-
monly, the date of the opinion of value and the date of the inspection of the property
are the same for appraisals of current market value. If the date of inspection differs

from the date of the opinion of value, then both dates should be noted in the apprais-
al report. If more than one value opinion is provided within the appraisal report, the
effective date for each value opinion must be provided.
Extraordinary (or Special) Assumptions, Hypothetical Conditions, and Jurisdictional Exceptions.
When a value opinion is subject to an extraordinary assumption or hypothetical
condition, the report must clearly and conspicuously disclose the assumption or
condition and state that its use might have affected the value conclusion. In the rare
case of a jurisdictional exception, the report must identify the law or regulation that
precludes the appraiser from complying with a part or parts of professional stan-
dards. The report must also cite the portion or portions of the professional standards
that are excepted because of the law or regulation.
General Assumptions and Limiting Conditions. General assumptions and limiting conditions
may be stated in the letter of transmittal, but they are usually included as separate
pages in the report. The general assumptions found in a typical appraisal report deal
with issues such as legal and title considerations, liens and encumbrances, property
management, information furnished by others (e.g., engineering studies, surveys),
concealment of hazardous substances on the property, and compliance with zon-
ing regulations and local, state, and federal laws. General assumptions and limiting
conditions should not be treated as boilerplate in the report, although they may be
typically applicable to almost all assignments. (Figure 33.7 shows examples of typical
general assumptions and limiting conditions.)
Scope of Work. A clear and accurate description of the scope of work performed in a
specific appraisal assignment helps the intended users understand the context of the
appraisal, and professional standards require that an appraisal report include enough
information to allow the intended users to understand the scope of work performed.
(For detailed information on scope of work, see Chapter 8 of this text.)
Providing a freestanding section in the appraisal report on the scope of work
helps the intended user find the discussion of what the appraiser did to solve the
appraisal problem, why the activities were performed, and who provided significant
professional assistance in the appraisal process. Alternatively, the scope of work of
the assignment can be discussed throughout the appraisal report within each respec-
tive section, e.g., discussion of the scope of the research and analysis of comparable
sales in the sales comparison approach section of the report.
Whether scope of work is discussed in its own section, throughout the appraisal
report, or in some combination of the two, the scope of work discussion must be clear
and not misleading.
Part Three—Presentation of Data

Legal Description. The subject real estate is identified so that it cannot be confused with
any other parcel of real estate. A street address may not be sufficient. Identification
of the property being appraised can be achieved by including a full legal description
of the property in the report or by reference to a unique identifying parcel number.
When a copy of the official plat or an assessment map is used, an appraiser may refer
to it at this point and present it on a facing or following page. If an official plat is un-
available, an appraiser can describe the property by name, specifying the side of the
street on which the property fronts, the street address, and the lot and block number.

Figure 33.7 General Assumptions and Limiting Conditions
The following assumptions and limiting conditions are commonly found in appraisal reports, but the specific wording
of the items and the inclusion of a specific item may not be applicable to every assignment:
This appraisal has been made with the following general assumptions:
• Title to the property is assumed to be good and marketable unless otherwise stated.
• The property is appraised free and clear of any or all liens or encumbrances unless otherwise stated.
• Responsible ownership and competent property management are assumed.
• Information furnished by others is believed to be reliable, but no warranty is given for its accuracy.
• All engineering studies are assumed to be correct. The plot plans and illustrative material in this
report are included only to help the reader visualize the property.
• It is assumed that there are no hidden or unapparent conditions of the property, subsoil, or structures
that render it more or less valuable. No responsibility is assumed for such conditions or for obtaining
the engineering studies that may be required to discover them.
• It is assumed that the property is in full compliance with all applicable federal, state, and local envi-
ronmental regulations and laws unless the lack of compliance is stated in the appraisal report.
• It is assumed that the property conforms to all applicable zoning and use regulations and restrictions
unless a nonconformity has been described in the appraisal report.
• It is assumed that all required licenses, certificates of occupancy, consents, and other legislative or
administrative authority from any local, state, or national government or private entity or organiza-
tion have been or can be obtained or renewed for any use on which the opinion of value contained
in this report is based.
• It is assumed that the use of the land and improvements is confined within the boundaries or property
lines of the property described and that there is no encroachment or trespass unless noted in the report.
• Unless otherwise stated in this report, the existence of hazardous materials, which may or may not be
present on the property, was not observed by the appraiser. The appraiser has no knowledge of the
existence of such materials on or in the property. The appraiser, however, is not qualified to detect such
substances. The presence of substances such as asbestos, urea-formaldehyde foam insulation, and other
potentially hazardous materials may affect the value of the property. The value estimated is predicated
on the assumption that there is no such material on or in the property that would cause a loss in value.
No responsibility is assumed for such conditions or for any expertise or engineering knowledge required
to discover them. The intended user is urged to retain an expert in this field, if desired.
• The forecasts, projections, or operating estimates contained herein are based on current market con-
ditions, anticipated short-term supply and demand factors, and a continued stable economy. These
forecasts are, therefore, subject to changes with future conditions.
This appraisal has been made with the following general limiting conditions:
• No responsibility is assumed for the legal description provided or for matters pertaining to legal or
title considerations.
• Any allocation of the total value estimated in this report between the land and the improvements
applies only under the stated program of utilization. The separate values allocated to the land and
buildings must not be used in conjunction with any other appraisal and are invalid if they are.
Providing a photograph of the subject property on a facing page can enhance this
section of the report.
Property History. When the value opinion to be developed is market value, USPAP, SVP,
and other appraisal standards require that current agreements of sale, options, and
listings of the subject property as well as sales of the subject property that occurred
within three years prior to the effective date of value be analyzed and addressed in
the appraisal report if available in the normal course of business. A discussion of how
the value estimate compares with recent sales of the subject is helpful to the reader

and is required by many clients. USPAP has no requirement to analyze the sales his-
tory of each comparable sale. However, Fannie Mae, Freddie Mac, and certain other
government bodies ask for sales histories of comparable properties, as reflected on
the URAR form. The Uniform Standards for Federal Land Acquisitions require sales
of the subject transacted within the past ten years to be reported.
For properties other than one-unit residences, recent changes in the property’s
operations should be addressed. Historical property data may include information on
• Original assemblage, acquisition, or construction costs
• Expenditures for capital additions or modernization
• Transfers of ownership
• Operating statements and financial data
• Casualty loss experience
• History and type of occupancy
• Any other facts that may pertain to or affect the computations, estimates, or con-
clusions presented in the report
Market Area, City, and Neighborhood Data. Relevant facts about the subject property’s market
area, city, and neighborhood should be discussed in the report. (The use and reliability
of different types of data in relation to various classifications of property and specific
appraisal problems are discussed in Chapters 9 and 11.) An appraiser weighs and
considers all pertinent factors in data analysis, but the report itself should discuss only
the data found to be significant to the appraisal problem. Both positive and negative
aspects of the market area should be discussed. If an appraiser only provides data in
support of either positive or negative factors, the report will be misleading, which is ev-
idence of bias and a lack of compliance with the ethical rules for professional conduct.
The amount of neighborhood and location data required depends on the informa-
tion needs of the intended users. For example, when an appraisal is prepared for an out-
of-town client who is unfamiliar with the property and the community, it may be wise to
include more community and neighborhood data than would be needed by a local client.
An appraiser should also note the presence of special amenities or detrimental
conditions in the neighborhood and provide reasons or data to support any conclusions
about these factors. For example, if an appraiser states that the market area is growing,
actual growth figures or building projections supporting that assertion should be in-
cluded in the report. If a report states that a neighborhood is in decline due to abnormal
deterioration or poor maintenance, an appraiser might refer to specific properties that
exhibit these detrimental conditions or use photographs to illustrate neighborhood con-
ditions. Photographs can also be used to show positive and negative value influences.
Reviewers have access to aerial photographs and maps on Google Earth and other inter-
net sites and can easily identify these influences. It is incumbent on appraisers to report
these positive and negative influences in the neighborhood or market area analysis.
Land Description. Pertinent facts about the subject site belong in the land description
section. Land description involves three different aspects of the subject property’s site:
• Legal characteristics

Relevant physical site data may include descriptions of the following:
• The property’s frontage, depth, site area, topography, and shape
• Soil and subsoil conditions
• Utilities
• Any improvements that benefit or harm the site
In the land description section of an appraisal report, an appraiser should offer a conclu-
sion as to the utility or adaptability of the site for existing or proposed improvements.
When significant to the appraisal problem, zoning and private restrictions (such
as easements) should be discussed in detail. The report should provide sufficient
land use data to help the intended users understand the limitations that zoning regu-
lations place on the use or development of the site. If the appraiser needs to explore
the possibility of a zoning change, this analysis should also be addressed. Other exist-
ing public and private restrictions such as floodplain regulations, scenic easements,
wetland restrictions, or covenants, conditions, and restrictions (CC&Rs) should be
discussed and their effect on the utility and value of the property described.
Improvement Description. In the description of improvements section of a report, all
building and improvement data relevant to the appraisal problem is presented and
discussed. Although an appraiser considers and processes aa great deal of data in the
course of an appraisal, only significant property characteristics that influence the value
conclusion are presented in the report. These characteristics may include the following:
• Actual and effective building age
• Building size
• Number and size of units
• Structural and construction details
• Mechanical equipment
• Physical condition
• Functional utility or inutility
Property information may be supported with drawings, photographs, floor plans,
and elevations. If the description of structural details and mechanical equipment is
long, an outline may be used in the body of the report to emphasize the important
items, and full details may be included in the addenda.
Tax and Assessment Data. Economic characteristics of a property that may have an effect
on its value and should be discussed in the appraisal report include
• Real estate taxes
• Special assessments
• Development bonds
• Facilities benefit districts or other public encumbrances affecting the site
Current assessed values and ad valorem tax rates should be reported, and, if relevant
to the assignment analyses or conclusions, a calculation of the current annual tax load
of the subject property should be included in the appraisal report. Existing assessment
trends or prospective changes in tax rates should be analyzed and reported. The likeli-
hood and potential effect of any overassessment or underassessment can be addressed.

It may be appropriate to discuss the tax assessment or tax load on the subject property
in relation to the taxes on other properties, particularly if the difference is significant.
Part Four—Analysis of Data and Conclusions

Market Analysis. Once an appraiser has gathered and presented all the data relevant
to the subject property and the valuation problem, the stage is set for the presenta-
tion of the appraiser’s detailed analysis of the market for the subject property. Many
appraisers structure this discussion around a six-step market analysis process, which
systematically answers a series of questions that a reader of the appraisal report
might ask. The conclusions of market analysis provide support for the analysis of al-
ternative land uses and ultimately the highest and best use conclusion. Market analy-
sis also provides economic data used in the application of the approaches to value.
Highest and Best Use. For an appraisal of market value, the appraisal report must set
forth a highest and best use opinion, including identification and analysis of the ef-
fect on use and value of existing land use regulations, reasonably probable modifica-
tions of those regulations, economic supply and demand, the physical adaptability of
the real estate, and market area trends, as outlined in appraisal standards.
It is a not appropriate to present only a statement of the appraiser’s highest
and best use conclusion. This is incorrect. An appraiser must summarize his or her
analysis and, if the objective is market value, some analysis of highest and best use
is required. In some cases, that analysis is quick and the highest and best use conclu-
sion is obvious—e.g., in the valuation of a single-unit residence located in a subdivi-
sion of similar houses where there is little chance that a likely buyer would demolish
the house and modification of the improvements would not significantly increase the
value above the cost. However, Standards Rule 2-2(a) of USPAP still requires a sum-
mary of the support and rationale for the highest and best use opinion.
It is not necessary to repeat sections of the report in the highest and best use analy-
sis. Report sections are not intended to stand alone. The market analysis and other
descriptive sections of the report can be used to support highest and best use conclu-
sions as well as the valuation sections. Material from other report sections may be
referenced in the highest and best use section to support the analysis and conclusions.
Land or Site Value. If land is valued as though vacant, a section of the report must ad-
dress this analysis. In the land value section, market data is presented along with an
analysis of the data and reasoning that lead to the land value opinion. The factors
that influence land value should be presented in a clear and precise manner, and the
narrative should lead the reader to the land value opinion.
Approaches to Value. In developing an opinion of value, an appraiser applies the ap-
proaches to value that are required to produce credible assignment results. In the
report, the appraiser describes the application of each approach and presents the
factual data, analysis, and reasoning leading to the value indication.
If the intended users are not familiar with the mechanics of the three approaches
to value, the appraiser should briefly explain the procedures applied. The extent of
explanation required depends on the circumstances of the assignment and knowl-
edge of the intended users. Simple statements that describe what is included in each
of the three approaches (such as those provided in Figure 33.8) can help readers bet-
ter understand the report.

Figure 33.8 Descriptions of the Approaches to Value—Examples
The approaches to value could be described in an appraisal report as follows:
In the sales comparison approach, properties similar to the subject property that have been
sold recently or for which listing prices or offers are known are compared to the subject
property. Data from generally comparable properties is used, and comparisons are made to
demonstrate a probable price at which the subject property would sell if offered on the market.
In the cost approach, an estimated reproduction or replacement cost of the building and
site improvements as of the date of appraisal is developed (including an estimate of entre-
preneurial profit or incentive), and an estimate of the losses in value (which is known as
depreciation) that have taken place due to wear and tear, design and plan deficiencies, or
external influences is subtracted. An estimate of the value of the land is then added to this de-
preciated building cost estimate. The total represents the value indicated by the cost approach.
In the income capitalization approach, the potential income of the property is calculated
and deductions are made for vacancy and collection loss and for expenses. The prospective
net operating income of the property is then estimated. To support this estimate, operating
statements for the subject property in previous years and for comparable properties are
reviewed. An applicable capitalization method and appropriate capitalization rates are
developed and used in calculations that lead to an indication of value.
Note that the description of the approaches to value may be more or less detailed depending on the level of detail
required by the report format and the sophistication of the client.
Reconciliation of Value Indications. Valuation standards require reconciliation of the data

within each approach as well as final reconciliation of the approaches used, except in
cases where only one approach is deemed necessary for credible assignment results.
In that case, there is only one reconciliation. That is, the reconciliation of value indica-
tions within the application of that one approach applied is the final reconciliation.
A reconciliation section consisting of boilerplate and stock comments does not
often present useful information. The final reconciliation section of the report includes a
discussion of the data used, its application to the subject, how the approaches apply to
the subject, and other information that is essential to a meaningful understanding of the
appraiser’s conclusions. The appraiser considers the strengths and weaknesses of each
approach, the availability and reliability of the data, and other concerns. The reconcilia-
tion of value indications should lead the reader logically to the final opinion of value.
Qualifications of the Appraiser. An appraiser’s qualifications may be included in the
report as evidence of the appraiser’s competence to perform the assignment. These
qualifications may include facts concerning the following:
• Professional experience
• Educational background and training
• Business, professional, and academic affiliations and activities
• Typical clients
• The types of properties appraised and the nature of the appraisal assignments
undertaken
Misrepresentation of qualifications or presenting misleading information regard-
ing qualifications is a breach of professional ethics. Ethical Rule 5-5 of the Appraisal
Institute’s Code of Professional Ethics states, “It is unethical to prepare or use in any
manner a resume or statement of qualifications that is misleading.”

Addenda
Depending on the size and complexity of the appraisal assignment, supplementary
material may be added to the report to present information that would interrupt
the narrative. The following items may be included in the addenda, if they have not
already been incorporated into the body of the report:
• Plot plan
• Plans and elevations of buildings
• Photographs of properties referred to in the report
• City, neighborhood, and other maps
• Charts and graphs
• Historical income and expense data
• Building specifications
• Detailed estimates of the reproduction or replacement costs of buildings
• Sales and listing data
• Leases and lease abstracts
Illustrations of many of the addenda items listed above can be seen in earlier sections
of this book.

Review 34
In common usage, the term review means to examine or critique. In appraisal practice,
review has a very specific meaning. A review is an opinion about the quality of an-
other appraiser’s work, where that work involved an appraisal or review. Review is
a valuation-related service that many different types of clients may need. The extent
and nature of a review is a scope of work decision reached jointly by an appraiser
and a client. There are distinct best practices and professional standards that apply
when appraisers provide this type of service.
For the purposes of the discussion in this chapter, a reviewer is an appraiser per-
forming a review, an appraiser is an appraiser whose work is being reviewed, and the
The Evolving Usages of Appraisal Review and Review

Historically, the valuation profession has referred to the common practice of providing a professional opinion
on the work of another appraiser as an appraisal review. Since the debut of the term in the professional
literature in 1945, the discipline has matured through the publication of journal articles and books on the
subject, the development of specific professional standards, and the more recent development of profes-
sional education devoted to the subject, which can lead to a professional designation for specialists trained
in the practice.
The original coinage of appraisal review seemed to limit the practice to a “review of an appraisal,” even
though modern thinking acknowledges that appraisers may perform reviews of both appraisals and reviews.
This scrutiny of the descriptive label has led to a more precise and broadly inclusive usage of simply review
to describe an opinion of another appraiser’s work, whether the work in question is an appraisal or another
review. That more succinct label has not yet achieved complete acceptance. For example, the Uniform Stan-
dards of Professional Appraisal Practice (USPAP) document continues to use the term appraisal review, while
the Appraisal Institute’s Standards of Valuation Practice (SVP) use review.
The SVP defines a review as “the act or process of developing and communicating an opinion to a client
about the quality of another’s appraisal or review report.” This slightly differs from how USPAP defines ap-
praisal review. In the SVP definition, the party whose work is under review is not specifically identified as an
appraiser. For example, a valuation professional may review the report of an economist or a real estate agent.
In this case, the review can appropriately be performed in compliance with both USPAP (the applicable
general rules) and the SVP (the applicable performance standards).
subject of the review is the work being reviewed. The subject of a review could be all
or part of an appraisal report or review report. It could be an oral appraisal report or
oral review report as well. All or part of an appraiser’s workfile could be the subject
of a review, either in conjunction with or in addition to a written or oral appraisal
report.1 A review may be limited only to certain parts of an appraisal report, e.g., the
review may be performed to evaluate the report’s compliance with standards. The
focus and extent of the review process is always a scope of work decision.
Most often, the subject of a review is an appraisal report prepared by another
appraiser. When that is the case, the review may or may not include an opinion about
the appraiser’s value conclusion.
Under USPAP, a service is not appraisal review if the work under review was pre-
pared by a nonappraiser. For example, an appraiser may be asked to “review” a broker’s
price opinion (BPO) prepared by a real estate agent. While an appraiser may certainly
provide this service, it is not appraisal review. However, if an appraiser agrees or disagrees
with the BPO presented by the nonappraiser, the appraiser would at that point be provid-
ing an appraisal, which would be subject to professional standards relating to appraisal.
An example of a service that is not a review under USPAP, the SVP, or the In-
ternational Valuation Standards (IVS) is one in which only facts about the work of
another appraiser are stated—for example, “the capitalization rate applied in the in-
come capitalization approach was 10%,” or “the appraisal report contained all items
required by USPAP for an appraisal report.” However, if a reviewer expresses the
opinion that the appraisal “complied with USPAP,” the reviewer would be providing
a review because making a determination about standards compliance involves mak-
ing a determination about quality.
For a service to be a review, the communication of the reviewer’s opinions and
conclusions must be provided to a client. If an appraiser provides an opinion about
the quality of another appraiser’s work only to the appraiser who performed the
work, no review service is being provided. In that scenario, one appraiser is simply
providing feedback to another. This is a common practice among appraisers and
serves to advance appraiser competence.
A review should never be used as an opportunity to discredit another appraiser.2
Nor should a reviewer criticize solely for the sake of criticizing. A reviewer’s findings
must be supported by evidence and logic (i.e., data and analysis). A reviewer must
at all times be aware that the role of a reviewer is to provide an unbiased, objective
opinion about the quality of the work under review. This stance must be maintained
regardless of the reason for the review. For instance, in litigation work, the role of
the reviewer’s client (usually an attorney) will be to advocate for the client’s cause or
objective. A reviewer, however, cannot assume such a role but instead must remain
an impartial third party whose role is to provide unbiased, objective information to
the client about matters pertaining to the quality of the work under review.
In a review assignment, it is possible that a reviewer will not find any errors or
weaknesses in the work being reviewed. The belief that a review report must mention
something negative about the work under review is incompatible with ethical practice.
1. The review of a workfile could pose challenges because the appraiser’s workfile is not required to be understandable to parties other than the
appraiser who prepared it. The workfile might include the appraiser’s shorthand notes that might not make sense to others.
2. Note that in litigation, judges, lawyers, and court decisions often refer to a review as a “rebuttal report.” However, whenever an appraiser comments
on the quality of another appraiser’s work, it is always a review service that must be performed in compliance with the professional standards
that it is subject to.

Reviewers must also keep in mind that their role is to review the work of ap-
praisers, not the appraisers themselves. In this regard, reviewers must be careful
about making statements about the competency of an appraiser. While substandard
work by an appraiser may suggest a lack of competency, reviewers should refrain
from expressing judgments about the individual and instead express judgments
about the work under review.
Why Reviews Are Needed

Reviews are performed to reinforce a client’s confidence in the credibility of the work
and its conclusions. A review, like an appraisal, is a decision-making tool. One use of
this tool is understanding risk. A user of an appraiser’s work (or anyone else who re-
lies on an appraiser’s work, such as a judge or jury) needs to be comfortable with the
opinion that the user will rely on, and a review provides the yardstick for measuring
the user’s comfort level. The appraisal profession is no different from other profes-
sions in that clients often seek second opinions from other professionals. Obtaining
reviews is a prudent business practice for users of appraisal services.
Reviews are critical to the decision-making processes of investors and assist judges
and juries in reaching informed decisions. Reviews are also critical for regulated lend-
ing institutions. The review requirements of US lenders may be tailored to their specif-
ic policies and procedures, which include compliance with the requirements of federal
agencies, most notably the Financial Institutions Reform, Recovery, and Enforcement
Act (FIRREA) of 1989, as amended by the Dodd-Frank Wall Street Reform and Con-
sumer Protection Act of 2010. Mortgage insurers have unique appraisal requirements,
as do federal and quasi-governmental agencies that conduct reviews as a normal part
of their appraisal acceptance and audit procedures and of their pre- and post-funding
reviews. State and local government agencies such as highway departments conduct
reviews in conjunction with the acquisition of rights of way and have specific appraisal
requirements for condemnation proceedings. Reviews are also critical in litigation and
other dispute resolution processes where the value of property is a pivotal question.
Reviews may be performed for quality control purposes, either within an ap-
praisal firm or by a user of appraisal services. However, when prepared within the
appraisal office for quality control purposes, the activity is not review as long as the
results are not communicated to a client. Some client groups, such as government
agencies and lending institutions, have quality control policies that call for regular,
periodic review of some segment of the appraisals they obtain. These quality control
reviews may serve to provide important lessons in hindsight for an appraiser, an ap-
praisal firm, or a user of appraisal services.
Who Can Prepare Reviews?

While anyone might form an opinion about an appraiser’s work, reviews as defined in
valuation standards are prepared by qualified appraisers according to those standards.3
3. The term compliance review has been used to describe a review performed by a nonappraiser or by an individual who may be an appraiser but is not
acting as an appraiser when providing the service. These reviews are generally for the purposes of checking factual accuracy or completeness only, not for
evaluating the quality of the valuation work. For example, individuals involved in loan processing often review appraisals to check their completeness for
loan underwriting purposes, and attorneys often review appraisals to check their completeness and factual accuracy for litigation purposes. Nonappraisers
are not expected to have appraisal competency and independence, and thus they are not expected to comply with professional appraisal standards.
Review 629
Appraisers are retained to perform these services because they possess competency in
valuation methods and techniques and because they are independent, objective, and
impartial. Freedom from bias is a key characteristic of a qualified reviewer.
In the United States, state appraiser licensing laws might require that a reviewer
be a licensed or certified appraiser in the state where the real property that is in-
volved in the assignment is located. A reviewer would be well advised to check with
the applicable state appraiser regulatory body before accepting a review assign-
ment. A review for a federally regulated lender must be prepared by a state-licensed
or -certified appraiser if the reviewer provides a different opinion of value and the
lender relies on that reviewer’s opinion.4
Because a defining characteristic of a professional appraiser is competency in
valuation methods and techniques, an appraiser acting as a reviewer must likewise
have the competency needed to provide credible appraisal reviews. However, the
competency level needed by the reviewer is different from the competency level
needed by the appraiser. The competency level needed by reviewers is dependent
upon the reviewer’s scope of work. For instance, if the reviewer’s scope of work
includes developing an opinion about the value of the property, then market area and
geographic area competency become very important. They may be less important if
the reviewer’s scope of work does not include agreeing or disagreeing with the ap-
praiser’s value conclusion.
A qualified reviewer generally has expertise with the property type involved in
the work being reviewed and with the methods applicable to the valuation of that
property type. A qualified reviewer also has expertise in review techniques, can iden-
tify the strengths and weaknesses of the work under review, and can discern between
major and minor errors and omissions.
Like an appraiser in an appraisal assignment, a reviewer must be able to judge
the level of competency needed for the review assignment prior to accepting it, and
then judge whether he or she has that requisite competency. This requires a good
understanding of the assignment—including the client’s problem to be solved, the
nature of the property involved, the intended use, and applicable laws and regula-
tions—at the outset. Reviewers must also have a good understanding of their own
skill sets.
Professional standards include competency requirements applicable to reviewers.
For example, USPAP’s Competency Rule and Standard B of the SVP apply to ap-
praisers acting as reviewers. The Code of Professional Ethics (CPE) of the Appraisal
Institute also contains requirements relating to competency. These require a reviewer
(or appraiser) to understand the problem to be solved in the assignment and the
competency level needed to solve it. Any lack of competency must be disclosed to
the client at the time of the assignment or as soon as it is discovered. If the reviewer
(or appraiser) is to proceed with the assignment, he or she must attain the needed
competency. The report subsequently provided to the client must disclose the initial
lack of competency and the steps taken to attain it.
A lack of competency will likely manifest itself in the quality of a reviewer’s work.
Without the requisite competency, the reviewer might overlook important issues or
fail to discern between significant and insignificant problems in the work under re-
view. This will result in a review that lacks sufficient credibility for its intended use.
4. Interagency Appraisal and Evaluation Guidelines, December 2010, section XV.

Applicability of Professional Valuation Standards
When an individual is “acting as an appraiser”—i.e., the client has engaged the indi-
vidual with the expectation that the individual has valuation expertise and is inde-
pendent, unbiased, and objective—professional standards apply to whatever service
is being provided. Standard B of the SVP applies to developing reviews and Standard
C applies to reporting. In USPAP, Standards 3 and 4 address the development and
reporting of a review. Reviewers may be required to comply with other standards,
laws, or regulations when preparing reviews. A reviewer must identify at the outset
the standards, laws, and regulations applicable to the assignment as well as any addi-
tional client requirements. For example, the Uniform Appraisal Standards for Federal
Land Acquisition (UASFLA) include specific requirements for review. When those
standards apply to an assignment, the reviewer must follow those requirements.
When performing fee review work for Fannie Mae, Freddie Mac, FHA, or the VA,
reviewers must follow specific guidelines and use a specific review reporting form. This
form (Fannie Mae Form 2000/Freddie Mac Form 1032) sets forth a minimum scope of
work for reviewers, which includes agreeing or disagreeing with the appraiser’s value.
In accepting an assignment using the form, a reviewer agrees that the scope of work will
include this determination. This agreement or disagreement is an appraisal opinion and
must be made in compliance with appraisal development standards. If the reviewer’s
scope of work does not include agreeing or disagreeing with the appraiser’s value pre-
sented in the appraisal report, then the review will not be acceptable for the purposes of
those governmental and government-sponsored enterprise clients or intended users.
Structuring a Review Assignment

The review process is an organizational scheme for thinking about the scope of work
of a review assignment and how to complete the assignment. This process provides
reviewers with a broad outline to ensure that key areas are being addressed. It also
gives appraisers insight into the thought process of reviewers and helps clients com-
municate with reviewers on the scope of work of their assignments. The seven steps
of the review process are as follows:
1. Identify the problem
2. Determine the reviewer’s scope of work
3. Examine the work under review
4. Develop opinions about the analyses, opinions, and conclusions in the work
under review
5. Develop opinions about the report under review
6. Develop the reviewer’s own opinion of value, when applicable
7. Prepare the review report, consistent with the intended use of the review
Different steps in the application of the process will be emphasized depending on the
scope of work of a specific review assignment.
The review process is similar to the valuation process. The connections between
the two are illustrated in Figure 34.1. Steps 1 and 2 and the final step of each process are
directly analogous. Steps 3 through 6 of the review process cover similar tasks as Step 3
through 7 in the valuation process. In a specific assignment, a reviewer may not need to
Review 631
632
Figure 34.1 Parallels Between the Review Process and the Valuation Process
The Review Process The Valuation Process
STEP 1 Identification of the Problem Identification of the Problem
Identify the Identify the Identify the Identify the Identify any Identify the Identify the Identify the Identify the Identify the Identify any
client and any intended use of purpose of the work under assignment client and intended use type and effective date relevant assignment
other intended the reviewer’s review review conditions intended users definition of the opinion characteristics conditions
users opinions and connected to of value of the
conclusions the review property
STEP 2 Reviewer’s Scope of Work Scope of Work Determination

STEP 3 Reviewer’s Research and Analyses Data Collection and Property Description
Consistent with the reviewer’s scope of work, examine the work under review regarding Market Area Data Subject Property Data Comparable Property Data
Completeness Accuracy Adequacy Relevance Reasonableness General characteristics of Subject characteristics of Sales, listings, offers,
region, city, and neighborhood land use and improvements, vacancies, cost and depreciation,
personal property, business income and expenses,
assets, etc. capitalization rates, etc.
STEP 4 Review of Appraiser’s Analyses, Opinions, and Conclusions
Develop an opinion Develop an opinion Develop reasons
Data Analysis
of whether analyses are of whether the opinions and for any disagreement
appropriate within the conclusions are credible within Market Analysis Highest and Best Use Analysis
context of the requirements the context of the requirements Demand studies Land as though vacant
applicable to that work applicable to the work; and Supply studies Ideal improvement
Marketability studies Property as improved
STEP 5 Review of Appraisal Report

Land Value Opinion
Develop an opinion Develop reasons
of whether the report is appropriate and for any disagreement
not misleading within the context of the
requirements applicable to that work; and Application of the Approaches to Value
Sales Comparison Approach Income Capitalization Approach Cost Approach
STEP 6 Development of the Reviewer’s Own Opinion of Value

When the scope of work includes the reviewer developing his or her own opinion of value Reconciliation of Value Indications and Final Opinion of Value
STEP 7 Reviewer’s Report Consistent with Intended Use Report of Defined Value
Source: Review Theory and Procedures: A Systematic Approach to Review in Real Property Valuation (Chicago: Appraisal Institute, 2015), 16.
perform the same sort of activities that an appraiser would when valuing the property
that is the subject of the work under review. However, a reviewer would certainly
need to know what an appraiser should do in that central portion of the valuation
process—i.e., data collection and property description, application of the approaches
to value, and so on—to develop an opinion of how well those steps were performed in
the appraisal under review. And, if the scope of work of the review assignment allows,
a reviewer may perform some similar tasks as an appraiser during the review process,
such as collecting and verifying market data and applying various techniques of the
approaches to value, to test the validity of the appraiser’s conclusions.
The work done in Step 3 of the review process applies to both developing and
reporting an opinion of the quality of the work under review. Step 4 deals exclusively
with the development of the value opinion in the work under review, while Step 5 deals
exclusively with the manner in which the work under review was reported. Step 6—the
development of the reviewer’s own opinion of value—is an optional component of a
review, depending on the scope of work of the assignment. Step 7 of the review process
addresses the review report, an essential component of every review assignment that is
required whether or not Step 6 is applied. Step 7 of the review process is similar to the
final component of the valuation process, the creation of the appraisal report.
The first step in a review assignment is to understand why the client needs
the review. All clients who engage reviewers seek to understand if the work to be
reviewed has enough credibility to be relied upon for its intended use. However,
many clients have specific reasons for obtaining reviews that go beyond that ques-
tion. For example, some clients want a reviewer to accept or reject an appraisal based
on certain criteria such as compliance with specific reporting requirements like the
Uniform Appraisal Standards for Federal Land Acquisitions. Other clients want the
reviewer to independently verify the data used in the appraisal and determine its ac-
curacy. Still others want the reviewer to verify the accuracy of the description of the
subject property—for example, site area, building area, physical characteristics such
as condition or location attributes, or legal characteristics such as zoning.
Not all clients are specific about their reasons for wanting a review, so it is
incumbent on a reviewer to consult with the client until those reasons are under-
stood. The reason (or reasons) that the client needs the review will translate into the
intended use of the review report. Once a reviewer has established the intended use
and intended users, the reviewer is obligated to determine and apply a scope of work
for that assignment that is appropriate for the intended use and to prepare a report
that is understandable to those intended users. Therefore, identification of the problem
to be solved in the review assignment is a critical first step. If the identification of the
problem is inadequate, the risk of a reviewer providing the wrong type of service and
not satisfying the client’s needs increases.
Once the problem to be solved is identified, the reviewer can determine the scope of
work. One of the most important steps in the review process is defining an appropriate
scope of work. Key questions affecting the scope of work decision include the following:
• What will be reviewed—an entire appraisal report, a portion of a report, a work-
file, or something else?
• Will the reviewer provide his or her own value opinion?
• Will the reviewer visit the property that is the subject of the appraisal (field or
desk review)?
Review 633
• Will the reviewer accept or reject the work under review according to certain criteria?
The reviewer should be careful to not let a review form or format drive the scope of
work. Many review forms (and formats) include a preset scope of work discussion.
When the reviewer uses such a form, it is understood that the minimum scope of
work will be stated in the form. However, the reviewer may determine that the scope
of work should be expanded.
Along with determining the scope of work of the review, the reviewer should
clarify with the client whether the reviewer is expected to communicate directly with
the appraiser regarding the work under review. Depending on the circumstances,
several different alternatives are possible:
• The reviewer will complete the review without having any contact with the ap-
praiser who completed the work under review.
• The reviewer will not know the identity of the appraiser who completed the
work under review.
• The reviewer will work with the appraiser from the point of the appraiser’s
engagement to provide guidance throughout and then review the work upon
completion by the appraiser.
• The reviewer will be engaged after the appraiser has completed the report, re-
view the report, and contact the appraiser to resolve any outstanding issues.
It is critical to clarify with the client prior to accepting the review assignment
which of the above alternatives is expected. If the expectation is that the reviewer will
have contact with the appraiser, the review assignment could present some addi-
tional challenges. These challenges include the need for interpersonal communication
skills as well as additional time to complete the assignment.
Development of the Review Opinion

Once the problem and scope of work have been identified, a reviewer is ready to
examine the work under review—i.e., read the report. As reviewers gain experience,
they tend to develop their own approaches to reading a report. When the subject of
the review is an entire appraisal report, some reviewers prefer to read it through from
beginning to end so they can get a sense of the report as the intended user or users
will see it. Other reviewers prefer to read the portions of the report that summarize
the key findings and conclusions and then focus on the sections of the report where
the key analyses are presented. For example, if upon reading the final reconciliation
section, a reviewer learns that the appraiser gave no weight to the cost approach, the
reviewer might spend little time reviewing the cost approach section. Conversely, if
the reviewer learns that a key risk factor for the property is its deteriorating condi-
tion, the reviewer might focus more attention on the portions of the report that ad-
dress how the property’s condition affects value.
A reviewer begins the process of analyzing the quality of the work under review
by noting evidence of the following five characteristics of both the appraiser’s devel-
opment process and reporting process:
• Completeness
• Accuracy

• Adequacy
• Relevance
• Reasonableness
These five characteristics cover the spectrum of what are considered measures of the
“quality” of the work under review.
In a review of an appraiser’s work, completeness implies both comprehensiveness
and thoroughness—i.e., nothing has been left out and the opinions and conclusions were
developed and presented carefully and in a sound manner. When the intended user fin-
ishes reading an appraisal report but has lingering questions about the work performed
or the results presented, that uncertainty suggests that the report is not complete.
For example, consider an appraisal report in which the zoning classification of
the subject property is stated to be “C4” without any explanation of what that desig-
nation means. The code “C4” might not be meaningful to the intended users of the
appraisal report if it is not explained by the appraiser, and understanding the highest
and best use analysis is impossible without understanding the zoning, which estab-
lishes the legally permissible uses of the site.
Another sign of potential incompleteness is a lack of explanation for the choice of
a capitalization rate from within a given range. The absence of this explanation gives
the appearance of an arbitrary decision on the appraiser’s part, i.e., an unsupported
conclusion. The lack of support for the capitalization rate used is particularly impor-
tant because small variations in the rates used to capitalize income into indications of
value have a significant effect on value and therefore the results of the appraisal.
In the context of the quality of work being reviewed, adequacy means that the
work satisfies the minimum requirements for its intended use. An appraisal de-
scribed as “adequate” would not necessarily serve as a model of best practices, but
it will meet professional standards. The adequacy of an appraisal relates to the scope
of work and the intended use. The needs of the intended user will not be met if the
scope of work is not adequate for the intended use.
To be adequate, an appraisal must also meet the current requirements of the
applicable professional standards. Compliance with current standards is a baseline
measure of professional competency. For example, an appraisal of market value that
does not include an opinion of the exposure time would not be compliant with valua-
tion standards, and thus the appraisal would not be adequate for the assignment.
Another example of a lack of adequacy would be an appraisal that fails to ad-
equately address relevant property characteristics. A user could reasonably believe
that the absence of discussion of potentially significant property characteristics
means that these characteristics were not analyzed in the appraisal, and the credibil-
ity of the value opinion would then be in question.
The accuracy of an appraisal relates to the data and the application of analyses
rather than the appraiser’s opinions and conclusions. That is, data can be described as
“accurate” or “inaccurate,” whereas an opinion is either “credible” or “not credible.”
Accuracy has two aspects: (1) correctness, or the absence of mistakes, and (2)
provability. An appraisal is provable if the data can be retrieved and the analyses
repeated. Replicable analyses are more likely to be accurate. They suggest that correct
data was used and a clear methodology was applied to perform calculations.
An example of a lack of accuracy would be an appraisal report with a narra-
tive discussion that differs from the summary provided. Another example would be
Review 635
inconsistency between a table of data and the narrative discussion of that data. Most
often, a lack of accuracy in an appraisal report involves computational errors, typo-
graphical errors in data entry, or the use of incorrect valuation methods. These errors
can be trivial or material.
A typographical error is not likely to be as significant a detriment to the accuracy
of the work as the misapplication of a valuation technique. Consider, however, the
effect of typographical errors in the application of the income capitalization ap-
proach. Suppose an appraiser analyzes the rents of comparable properties and shows
a conclusion of $12.00 per square foot, but the calculations in the report use $11.50
per square foot. This sort of material error arising from a simple typo can also occur
in the application of a capitalization rate. For example, the narrative discussion of
capitalization rate analysis might state that an 8.5% rate was used, but 9.0% appears
in the tables and calculations in the report. These typos obviously can have a signifi-
cant effect on the value conclusion.
The appraisal analysis needs to be applicable to the problem, and appraisal
reports need to be succinct. The inclusion of too much irrelevant information is a
common problem with appraisal reports. By the same token, the report must not lack
relevant information. The appraiser should address what the client needs to know.
The report document should connect the dots for the intended user of the appraisal
and provide all the relevant information that the intended user needs to understand
the results of the assignment.
The quality of relevance has four aspects. The information presented should be
1. Connected
2. Applicable
3. Useful
4. Significant
The content of an appraisal report is connected if it is directly or indirectly relevant
to the conclusion of the work. Applicable content is important to the outcome. Useful
content has practical value. And content that is significant is essential to the user’s
understanding.
An appraisal report that leads the intended user to the opinion of value with ap-
plicable evidence and logic would be exhibiting relevance. Ultimately, the relevance
of a report is demonstrated by how well the assignment results connect with and are
based on the data, analyses, and discussion of the content presented in the report.
Evaluating reasonableness is not exclusive to appraisal. In many professions in
which opinions are important, the quality of work is often judged by the reasonable-
ness of the opinions presented. In a sense, reasonableness is the flip side of negligence.
Appraisers test the reasonableness of their analyses and conclusions in the con-
text of the intended use of the appraisal. What other appraisers would do in the same
situation is a standard test of reasonableness. Similarly, the body of knowledge relat-
ing to valuation (such as books, appraisal courses, and other literature) and require-
ments in published standards (such as the SVP, USPAP, and the IVS) are typical tests
of reasonableness. An appraisal that passes the test of reasonableness will be realistic,
balanced, objective, and adequate for the purpose of the assignment.
One key review function is making judgments about the quantity and quality of
the data and analyses in the work under review. A competent reviewer knows when

issues are important or immaterial. Throughout the review process, a reviewer must
remain cognizant of, and stay focused on, the objective of the review assignment,
which is to inform the client about the quality of the work under review so that the
client can decide whether or not the work can be relied upon for its intended use. The
reviewer must be able to discern when judgments made in the work under review
are acceptable and when additional supporting data and analyses are needed given
the intended use.
A review of an appraisal report must be conducted in light of the market condi-
tions as of the effective date of that appraisal. A reviewer must consider the data and
information that the appraiser could have or should have uncovered at the time the
assignment was performed. It is unreasonable to expect the appraiser who prepared
the work under review to be responsible for knowing something that was not know-
able at the time.
Providing an Opinion of Value as a Reviewer

If the scope of work of a review includes the reviewer providing his or her own value
opinion for the subject of the work under review, then providing support for any dis-
agreement about the final value opinions presented in the work under review will be
a matter of supporting the reviewer’s own opinion of value. Remember that the de-
velopment of the reviewer’s own opinion of value constitutes an appraisal subject to
the professional standards for the development and reporting of an opinion of value.
In contrast, if the reviewer’s own value opinion is not part of the assignment, the
reviewer has to be careful when providing reasons for disagreement. There is always
the possibility that a reviewer expressing disagreement with an appraisal will make a
statement about the appraiser’s value opinion that, in effect, serves as the reviewer’s
own opinion of value, which might not be the reviewer’s intent.
A reviewer might disagree with any number of components of an appraisal other
than the opinions of value. Examples of portions of an appraisal that a reviewer
might disagree with include property analysis, site valuation, cost analysis, the
adjustment of comparable sales, or income analysis. If the reviewer’s scope of work
includes providing his or her own opinion of value, the reviewer will need to provide
a new analysis of the portion of the work that is the subject of any disagreement. If
the scope of work does not include the reviewer’s own opinion of value, the reviewer
might simply note the concern as a quality issue.
Extraordinary or special assumptions play a key role in the review process when a
reviewer is providing an opinion of value in the review report. For example, a reviewer
might agree or disagree with an appraiser’s value opinion presented in an appraisal
report, but if the reviewer’s scope of work does not include verification of the informa-
tion presented in the appraisal report about the property, the reviewer’s opinion of
value is based on the assumption that the property information presented in the report
under review is accurate. The reviewer must then include a statement in the review re-
port to this effect and also state that if the assumption proves to be false (i.e., the prop-
erty information in the report is inaccurate), the reviewer’s opinion could be different.
Another situation in which an extraordinary or special assumption is made by
a reviewer is when the reviewer’s scope of work includes providing an opinion of
value but does not include doing an independent search for comparable data. In this
case, whether the reviewer agrees or disagrees with the appraiser’s value conclu-
Review 637
sion, the reviewer would be basing the conclusions on the assumption that the data
presented in the report under review is accurate and is the best available data. Again,
the reviewer must include a statement in the review report to this effect and also state
that, if the assumption proves to be false (i.e., the data is inaccurate or better data
would have been available), the reviewer’s opinion could be different.
Clear disclosure of extraordinary or special assumptions is critical—and is re-
quired by professional standards—so that the client and intended users of the review
report can determine its suitability for their use. Clients might decide, for example,
that their comfort level with the review and the underlying appraisal would be en-
hanced if the reviewer’s scope of work was expanded so that extraordinary assump-
tions are not necessary. Or clients might find that the appraisal review report meets
their needs, even though it is based on certain extraordinary assumptions.
Reporting the Review Opinion

Clear communication of the reviewer’s findings is a critical step in a review assign-
ment. The communication could take one of several forms:
• An oral report
• A written report using a standardized form or format
• A written report in a format created by the reviewer or the client
Oral review reports may be used in cases where the client does not need a writ-
ten report. In those cases, a reviewer and client might meet, in person or by phone,
to discuss the work under review. Oral review reports may also be used in situations
involving testimony, such as court testimony or a deposition of a reviewer.5
When an oral review is provided, a reviewer must develop the review opinion
prior to delivering the oral report. A reviewer cannot be expected to provide an
opinion about another appraiser’s work on the spot. The development of a review
opinion requires due diligence, and that takes time. The reviewer must ensure that
the review has been properly developed and a workfile in support of the review has
been created prior to delivering the oral report.
As mentioned earlier, if the review report is to be in writing, the client might re-
quest that a standardized form or format be used.6 Reviewers who are not employed
by lending institutions and are conducting one- to four-unit residential property
appraisal review work generally use Fannie Mae Form 2000/Freddie Mac Form 1032.
For other property types, there is no single, widely used form or format. Different cli-
ent groups have created their own forms and formats that meet their specific needs.7
Any form may require supplemental detail to make it conform to the standards that
the assignment is subject to.
If a reviewer is writing a narrative report or creating his or her own format, the
reviewer must make sure that (1) the review report complies with applicable profes-
5. Note that a review report provided in testimony is only considered to be an oral report if the testifying expert has not already provided either a
written or oral report to his or her client. If a written or oral report has already been provided to the client, the expert is simply talking about that
report at the deposition or trial and is not providing a separate oral report.
6. A text or email is considered written communication. Also, if an oral review report is provided and the client subsequently requests “written follow-
up,” that written communication is a written review report if it contains the reviewer’s opinion about the quality of the appraiser’s work.
7. Developing a single, standardized review form for all review assignments is difficult because the information that needs to be conveyed in a review
report varies greatly with the property type and the reviewer’s scope of work. A form or format that is sufficient for one review assignment might
be insufficient for another assignment and, at the same time, be overly detailed for a third assignment.

sional standards for reporting an appraisal review and (2) the review report meets
the needs of the client and any other intended users.
Professional standards require the inclusion of the following items, at a mini-
mum, in a review report:
1. The reviewer’s client and any other intended users.
2. The intended use of the review. (Why does the client need the review?)
3. The purpose, or objective, of the review, including whether the assignment is to
include the development of the reviewer’s own opinion of value. (What is the
client’s question about the work under review?)
4. The subject of the review assignment. (What is being reviewed?)
a. The ownership interest of the property that is the subject of the work under
review.
b. The date of the work under review (i.e., the date of the report).
c. The effective date of the opinions and conclusions in the work under review.
d. The appraiser who completed the work under review.
5. The date of the review report.
6. When the scope of work includes the reviewer’s development of an opinion of
value, extraordinary assumptions and hypothetical conditions used by the review-
er and a statement that their use might have affected the reviewer’s conclusions.
7. The reviewer’s scope of work.
8. The extent of any significant appraisal or review assistance provided by others,
if any.
9. The reviewer’s opinions and conclusions about the work under review, including
the reasons for any disagreement.
10. When the scope of work includes the reviewer’s development of an opinion of
value, a statement of which information, analyses, opinions, and conclusions in
the work under review the reviewer accepted as credible and used in developing
the reviewer’s own opinion; the effective date of the reviewer’s opinion of value;
and a summary of any additional information relied on and the reasoning for the
reviewer’s opinion of value.
11. The reviewer’s signed certification.
When the reviewer is subject to USPAP, the applicable performance standard
for the development and communication of the review is Standard 3. The reporting
requirements for a review are set forth in Standard 4.
Unless otherwise required, a review report need not repeat what is in a report
being reviewed. The purpose of the review report is not to summarize or reiterate the
work under review. Instead, the purpose is to provide the client with the reviewer’s
clearly explained opinion about the quality of that work.
The Reviewer’s Workfile

Professional standards requirements, including the Code of Professional Ethics of the
Appraisal Institute and USPAP, require the retention of records for review assign-
ments. The records, or workfile, must be retained for a minimum of five years, or a
minimum of two years after the final disposition of any judicial proceeding in which
Review 639
the reviewer gave testimony relating to the assignment, whichever is longer. Either
the workfile must be in a reviewer’s possession, or the reviewer must have an agree-
ment that addresses retention, access, and retrieval arrangements with the party in
possession of the workfile.
When a written review report is provided to a client, the workfile for the assign-
ment must include the following:
• A true copy of the reviewer’s review report. This may be documented on any
type of media—e.g., it can be an electronic copy—as long as it is an exact copy of
what was given to the client.
• Any additional data, information, or documentation necessary to support the
reviewer’s findings or reference to the location of the documentation. A copy of
the work under review is generally necessary to meet this requirement.
When an oral review report is provided to a client, the workfile for the assign-
ment must include the following:
• The identity of the client and any other intended users.
• All information necessary to support the reviewer’s opinions and conclusions—
in essence, enough information to prepare a written review report.
• Any additional data, information, or documentation necessary to support the
reviewer’s findings or reference to the location of the documentation. A copy of
the work under review is generally necessary to meet this requirement.
• The reviewer’s signed and dated certification.
• A summary of the oral review presented by the reviewer. If the oral review was
given only as oral testimony at trial or in a deposition, a transcript of the review-
er’s trial or deposition testimony suffices.
In addition to the minimum requirements listed above, as a matter of good business
practice, a reviewer might want to retain other work notes, a copy of the engagement
letter, and copies of other communications with the client and with the appraiser.
Common Issues Found in Reviews

The challenges faced by reviewers are tied directly to the most common problems
encountered by appraisers. Difficult appraisal assignments will often lead to difficult
review assignments. Some reviewers use checklists to help ensure that they perform
the review function competently and completely. The checklist shown in Figure 34.2
lists the sort of problems reviewers commonly find in appraisal reports.
Regardless of the scope of the review process and the tools applied, a reviewer’s
conclusions should be communicated professionally and without bias. The impor-
tance of review has increased in recent years with more oversight of government
agencies, financial institutions, the courts, and other businesses. Ideally, the review
process can raise the level of professionalism among appraisers and encourage them
to produce high-quality appraisal reports. Reviewers are sometimes seen as gate-
keepers of the appraisal profession, and they do hold practitioners responsible for
their work product. Although this role is challenging, the review process can be an
educational and rewarding exercise for the reviewer and appraiser and, if performed
properly, will improve client satisfaction and confidence.

Figure 34.2 Common Issues in Appraisals of Concern to Reviewers
Portion of Appraisal Report What to Expect What to Watch For
Letter of transmittal Introduction of the • Statements that raise questions not answered in
report to the client the body of the report
• Indications that the assignment was not as requested
• Unusual limiting conditions
• Errors or inconsistencies with content in the body
of the report
• Boilerplate, especially about assignment conditions
Certification • Statements required • Changes to standards language that change the
by professional meaning
standards • Additional certification statements that conflict
• Additional statements with professional standards
required by professional • Omission of any of the statements required by
organizations professional standards
• Failure to name appraisers who provided
significant assistance (and failure to describe what
they did)
• When the applicable standards are USPAP, failure
to include indication of inspection (or not) for all
signees
• When the applicable standards are USPAP, failure
to include statement about prior services (three
years)
Summary of important Quick synopsis of the • Information or conclusions contradicted elsewhere
conclusions report to follow in the report
• Unusual limiting conditions
• Confusing information
Identification of the client, Clear statements of • Failure to state the client’s identity
other intended users, and all three items • Misunderstanding of the concepts of intended use
intended use and intended user
Identification of the subject Clear identification of • Ambiguous or vague property identification
real property the real property information
involved in the appraisal • Lack of this information
Identification of the property Clear statement or • Obvious evidence that the appraiser was not clear
rights appraised description about interest
• Use of only a label when a full description is
warranted
Type and definition of value Definition and source • Lack of value definition or its source
cited • Inconsistency between type of value and valuation
process applied
• Providing liquidation or disposition value but calling
it “market value”
Effective date of the value Clearly stated dates • With multiple value opinions, lack of clarity about
opinion and date of report which date goes with which value opinion
• Inconsistency between the date of value and the
valuation process applied
• Lack of statement of date of report
Assignment conditions— • Clear and conspicuous • Statements identified as one of the types of
extraordinary assumptions, statement of conditions assignment conditions when they are not
hypothetical conditions, etc. • Statement that their • Failure to identify and describe assignment
use might affect conditions that were applied in the valuation.
assignment results
General assumptions and Standardized boilerplate, • Unusual limiting conditions that would impair the
limiting conditions tailored to be relevant client’s ability to use the report
Review 641
Figure 34.2 Common Issues in Appraisals of Concern to Reviewers (continued)
Scope of work Clear statement of scope • Discussion that is clearly boilerplate
(may be in a single • Vague statements, e.g., “Relevant data was
section, various parts of researched.”
report, or a combination • Inadequate explanation for omitting valuation
thereof) analyses or data that would be expected
Legal description (if included) Clearly presented • Incorrect legal description for the property being
descriptions from appraised
authoritative source • The statement “See addenda” but the legal
description is not found there
Identification of non-realty items Personal property or • Lack of clarity about items included in value
intangibles included opinion
• Lack of clarity about what items are included in
the comparable data
• Improperly developed opinions of value of
non-realty items
Ownership history, including • Sales within three • Statements that sales, etc. occurred but failure to
prior sales, current listings, years, current listings, analyze them
current options or options • Failure to analyze a relevant transaction
• Current or recent
offers with information
relevant to the
valuation
Market area and location Clear description of • Abundance of irrelevant information
information information relevant to • Lack of relevant information
the appraisal problem • No connection between the information presented
and the valuation problem
Description of site Relevant, understandable • Abundance of irrelevant information
information that is • Lack of relevant information
presented clearly • No connection between the information presented
• Little more than disclaimers about the appraiser’s
responsibility
Description of improvements Relevant, understandable • Abundance of irrelevant information
information that is • Lack of relevant information
presented clearly • No connection between the information presented
Taxes and assessment data • Clear presentation • Unexplained inconsistencies between actual taxes
of property taxes and taxes used in the income capitalization
and assessment approach
data
• If relevant, description
of local assessment
practices
Zoning and other land Land use regulations, • Lack of explanation of land use regulations and
use regulations what they mean, and permitted uses
uses allowed
Market analysis Clear and meaningful • Lack of adequate market analysis
discussion of market • Conclusions that are inconsistent with the
area, etc. information presented

Figure 34.2 Common Issues in Appraisals of Concern to Reviewers (continued)
Highest and best use analysis If appropriate, clear • Simply stating highest and best use without
discussion of analysis providing analysis
• Lack of support for conclusions
• Gaps in analysis requiring leaps of faith from
reader
• Failure to incorporate information from the market
analysis process
Cost approach • Meaningful • Misapplication of the methodology
presentation of site • Double-counting depreciation
value • Depreciation estimate based solely on cost services
• Support for site value • Confusion over entrepreneurial incentive
• Support for • Improper application of age-life depreciation
improvement costs concepts
• Inadequate treatment of superadequacies
Sales comparison approach Meaningful • Math mistakes
presentation of analysis • Failure to use the appropriate unit of comparison
of comparable sales • Use of comparables that are not truly comparable
• Use of properties with dramatically different
tenancy profiles
• Combining adjustments that should be considered
independently
• Improper use of bracketing
• Inconsistent adjustments
• Failure to address sales that should have been used
Income capitalization approach Meaningful presentation • Basing market rent estimates on asking rents only
of • Lack of support for expense estimates
• all sources of income • Misuse of gross rent multipliers
• vacancy and • Use of a net income multiplier as well as direct
collection loss capitalization (not separate, independent
• operating expenses approaches)
• capitalization or • Confusion over distinction between RO and YO
discount rates
• rates of change
(and terminal
capitalization rate),
if applicable
Reconciliation and final Meaningful discussion • Boilerplate statements
opinion of value of strengths and • Failure to reconcile differences in indications of
weaknesses value
• Introduction of new data that was not previously
presented
• Averaging without adequate justification of why it
is appropriate
• Conclusion that is inconsistent with reconciliation
discussion
Estimate of exposure time Clear statement of • Misunderstanding of the concept
amount of time needed • Unreasonable estimate given market evidence
for exposure • Lack of support
• Confusion between exposure time and
marketing time
Source: Adapted from Review Theory and Procedures: A Systematic Approach to Review in Real Property Valuation (Chicago: Appraisal Institute,
2015), 82-85.
Review 643
Consulting 35
Because of their expertise and experience, appraisers may be called upon to provide
services that do not involve appraisal or review opinions. These services—loosely
referred to as “consulting”—range from simply providing market data to providing
advice about real estate industry standards and practices or a recommendation such
as whether to invest in a property or whether the contemplated design of a project
conforms to market tastes.
Consulting is a generic term that encompasses a broad variety of advisory services,
and the term should be used with care. Many services provided by an appraiser could
be classified as consulting according to common dictionary definitions. To avoid being
misleading, consulting should be used only in conjunction with a description of the type
of consulting being discussed. Some consulting assignments involve the development
of value or review opinions, and some do not. Either way, if the client expects the indi-
vidual hired to have valuation expertise and to provide the service in an unbiased, ob-
jective manner, that individual is acting as an appraiser and professional standards apply
regardless of whether the service includes providing an appraisal or a review opinion.
Many consulting services require specialized knowledge and skills, and addition-
al study and experience in these areas may be required. Appraisers must be particu-
larly careful when providing consulting or advisory services to properly identify the
client’s problem to be solved and advice sought as well as to ascertain whether they
have the required competence to solve that problem.
If the consulting service does not involve providing valuation or review opinions,
there are no performance standards applicable to the development or reporting of the
service. However, requirements relating to ethics and competency apply. For example,
if the appraiser is subject to the Uniform Standards of Professional Appraisal Practice
(USPAP), then the ethics and competency rules of USPAP would apply. If the ap-
praiser is a Member, Candidate for designation, or Practicing Affiliate of the Appraisal
Institute, the Appraisal Institute’s Code of Professional Ethics (CPE) would apply.1
1. Technically, USPAP’s Preamble, Definitions, and Jurisdictional Exception Rule would also apply. The Record Keeping Rule and Scope of Work Rule
would not apply.
Some consulting services do include a valuation, and this appraisal portion of the
service is subject to the applicable development and reporting standards. In these cir-
cumstances, one or more appraisal opinions are “wrapped into” a consulting service.
That appraisal may be prepared by the appraiser engaged in the consulting service,
or it may be prepared by another appraiser. If the appraisal is prepared by another
appraiser, the consulting appraiser may either: (1) review the appraisal report and
agree with it (or disagree and provide an alternative
value conclusion) or (2) rely on the other appraiser’s
If the objective of the appraisal report and premise the consulting conclusion
assignment is to express on the special/extraordinary assumption that the ap-
an opinion about another
appraiser’s work, then the praisal it relies on is credible. This latter approach may
assignment is not consulting be appropriate when the consulting appraiser lacks the
but rather review. competency (particularly geographic or market area
competency) to value the property, but is competent to
complete the rest of the consulting analysis. This latter
approach may also be appropriate when the valuation
portion of the consulting service is less critical to the final recommendation or conclu-
sion of the consulting service. Regardless, the consulting appraiser should rely on the
work of another only if the consulting appraiser has no reason to doubt its credibility.
Feasibility Studies
An example of a consulting service that encompasses an appraisal is a feasibility
study. The objective of a feasibility study is not to develop an opinion of value, but
rather to draw a conclusion about feasibility, which is usually assessed by determin-
ing whether the financial benefit (i.e., the value) of an action or project is equal to
or greater than the cost, or to analyze alternative actions or projects. In a feasibility
study, the appraiser develops an opinion of value for a proposed land use and tests
the feasibility of that use by comparing costs and benefits.
Cost-Benefit Studies
Appraisers conduct cost-benefit studies on either a macroeconomic or microeconomic
basis. For example, a community might require a cost-benefit study to determine the
economic benefits that would most likely result from a new public project such as an
expressway or a sewage treatment plant. The cost-benefit study would focus on the
relationship between the benefits created and the costs associated with the project to
determine whether the benefits warrant the costs.
Some public bodies hire an appraiser to determine the preliminary effect of a
project. This may entail the assessment of project risk as well as the cost of imple-
menting various project scenarios. For example, a road-widening project that results
in diminished access to a commercial site may significantly reduce the value of the
property, for which the owner must be compensated. This will add to the cost of the
public project, which must be considered in the decision-making process.
Developers also use cost-benefit studies, particularly when they are called upon
to install major items. A cost-benefit study can establish the relative worth of the
expenditures in relation to the expected benefits.

In some cases, a cost-benefit study may involve an appraisal. An appraiser must
carefully consider what the service involves and the valuation standards that may apply.
Pricing and Rent Projection Studies

Pricing and rent projection studies may be components of marketability studies or
the subject of separate studies. These analyses are frequently conducted to establish
sales and marketing strategies for real estate projects and to facilitate decisions in-
volving property management and investment. In some cases, such a study includes
an appraisal.
Property Tax Services

Property owners have the right to appeal the ad valorem assessments on their real
property, and appraisers are often hired to provide a professional opinion of value
in a dispute over the assessed value. Most property tax consulting work involves an
appraisal, but on occasion the basis for the appeal is something other than value—
for example, the assessor’s records show an incorrect building or land area, or the
records are otherwise incorrect regarding property characteristics. The use of ratio
studies and equitable assessment studies may be appropriate in this context.
Property owners seeking a property tax deduction will generally claim that their
properties are overvalued and/or that their properties were not assessed equitably,
but appraisers must remain unbiased and report their conclusions of the defined
value regardless of whether the value opinion is higher or lower than the assessed
value. The appraiser cannot be an advocate for the property owner and cannot accept
a fee contingent if the applicable standards are USPAP.
Specific challenges to proper appraisals for assessment purposes include
• Potentially dramatic changes in property values from year to year
• Income-producing properties that outperform the local competition
• Special-use properties that are assessed at use value rather than market value
• Identification of the relevant property interest to tax
• The increasing diversity and specialization of property types2
Appraisers working on property tax appeal assignments deal with these issues
regularly. For example, in a market with volatile pricing and demand, the appraiser’s
research and collected evidence of the rapidly changing market conditions will be of
critical importance to a successful application for tax abatement.
Two important areas of investigation in a property tax appeal assignment are the
classification of the property and any tax exemptions that may apply. If a property is
improperly classified in the jurisdiction’s records, the assessed value is unlikely to be
appropriate for the actual use of the property. Similarly, an appraiser’s research into
the economic characteristics of a property could reveal unclaimed tax exemptions
that the property owner would benefit from knowing about.
2. Robert W. Owens, “Valuation and the Property Tax,” The Appraisal Journal (July 2000): 342-346.
Consulting 647
Litigation Support
Real estate is often the subject of litigation. Appraisers are frequently called upon
to testify in court regarding appraisal methodology, appraisal standards, or the
value of property involved in a dispute. Principles and processes established by the
US Supreme Court may create a need for the court to seek testimony to qualify (or
disqualify) someone offered as an expert witness.3 Methodology and standards tes-
timony typically involves generally accepted valuation principles and methods and
applicable appraisal standards.
Appearing as an expert witness is a common assignment that may involve ap-
praisal, appraisal review, or consulting services. Behind the scenes, appraisers pro-
vide litigation support in other ways by investigating information about the subject
property or comparable properties that may be useful to the case, helping organize
the testimony of other expert witnesses, or suggesting other experts for the attorney’s
team. Attorneys and their clients may also ask appraisers to assist in the discovery
process, to prepare questions for the examination or cross examination of witnesses,
and to advise on the preparation of graphics to be presented in court.
Appraisers can often offer expert advice in cases involving the dissolution of a
business partnership or a marriage. In addition to advising on the value of jointly
held real estate assets, appraisers may counsel the parties as to the allocation of their
holdings. For example, the appraiser may be able to help settle a dispute between one
partner, who is willing to assume the risks and responsibility of owning a manage-
ment-intensive asset, and another, who wants to retain only assets that provide cash
flow with little risk.
Advocacy must be avoided when an appraiser serves as an expert witness. While
attorneys are acknowledged to be advocates for their clients, appraisers can only ad-
vocate for their own value opinions in order to comply with professional standards.
An appraiser on the witness stand who is seen as an advocate for the attorney’s client
loses credibility as an independent and objective analyst. Professional standards usu-
ally distinguish between acting as an appraiser and performing a consulting service.
Regardless of the role the appraiser assumes, he or she cannot misrepresent that role
in the process of completing the assignment.
Arbitration
Another example of an appraiser serving as a consultant is in the role of an arbitra-
tor. Appraisers may act as a sole arbitrator or more often as a member of a panel of
arbitrators. Such panels typically consist of three arbitrators. Although other issues
may be involved, the most common objective of the arbitrators is to determine the
market value or market rent of a specific property. That determination may be based
solely on the appraisal reports submitted or it may involve more formal proceedings
that include sworn testimony and questioning of expert witnesses by adverse parties,
typically lawyers.
3. John D. Dorchester Jr., “The Federal Rules of Evidence and ‘Daubert’: Evaluating Real Property Valuation Witnesses,” The Appraisal Journal (July
2000): 290-306.

Other Consulting Services
Some other assignments that fall under the broader category of consulting services
include
• Land use studies
• Market studies
• Marketability studies
• Due diligence for a client’s acquisition or sale decision
• Operations audits
• Absorption analysis
• Risk analysis
• Portfolio analysis
• Adaptive reuse analyses—i.e., analysis of an existing property’s proposed change
of use
• Property inspections
• Capital market analyses
Consulting services are often provided to assist clients in making decisions about
the acquisition or disposition of real estate, the development or redevelopment po-
tential of a property, and the financial management and planning of alternative real
estate investments. The specific services performed for a client must be tailored to the
individual circumstances.
Consulting 649
Valuation for Financial 36
Reporting
The appraisal specialty of valuation for financial reporting (VFR) is tied to account-
ing practice. In VFR assignments, appraisers are called on to assist in the analysis
and presentation of financial data used to give owners, investors, and regulators an
objective picture of the economic performance of a company. Real property valuation
professionals have a special role in the calculation of the “fair value” of assets and
liabilities in real property, which may be required information in a company’s annual
report, prospectus, or SEC Form 10-K.
The US Financial Accounting Standards Board (FASB)—which establishes and
maintains the professional standards relevant to US generally accepted accounting
principles (GAAP)—defines fair value as “the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market partici-
pants at the measurement date.” As discussed in Chapter 6, this accounting defini-
tion is close to the commonly cited definitions of market value used by valuers1 of real
property, as shown by the color-coordinated commonalities in Figure 36.1. Because
of the similarity in these concepts, accountants may use the market value opinions of
valuers as evidence of fair value in their financial reports.
Fair value is the standard of value expressed in financial accounting standards
that provides information to investors about the price an asset could be sold for at the
measurement date. The fair value standard does not provide information on the an-
ticipated internal rate of return or future results that the current investors are expect-
ing. The reporting of an appraisal prepared for financial reporting purposes might be
different from the reporting of an appraisal prepared for, say, a bank. For example,
the appraisal of an office building owned by a real estate investment trust for five
years would not likely require an in-depth description of the property in an appraisal
report prepared for financial reporting purposes because the management of the
REIT that requested the report is already familiar with the property. A bank, on the
1. In many parts of the world, the term valuer is more commonly used than appraiser to describe a person who performs a valuation, and who is
often licensed to do so.
Figure 36.1 Comparison of Definitions of Value
fair value market value
The price that would be received to sell an asset or paid The most probable price that a property should bring
to transfer a liability in an orderly transaction between in a competitive and open market under all
market participants at the measurement date. conditions requisite to a fair sale, the buyer and
seller each acting prudently and knowledgeably, and
assuming the price is not affected by undue
stimulus. Implicit in this definition is the
consummation of a sale as of a specified date and
the passing of title from seller to buyer under
conditions whereby:
• Buyer and seller are typically motivated;
• Both parties are well informed or well advised, and
acting in what they consider their best interests;
• A reasonable time is allowed for exposure in the
open market;
• Payment is made in terms of cash in U.S. dollars
or in terms of financial arrangements comparable
thereto; and
• The price represents the normal consideration for
the property sold unaffected by special or creative
financing or sales concessions granted by anyone
associated with the sale.
FASB Accounting Standards Codification Topic 820: Fair Value 12 C.F.R. Part 34.42(g); 55 Federal Register 34696, August 24,
Measurements and Disclosures 1990, as amended at 57 Federal Register 12202, April 9, 1992;
59 Federal Register 29499, June 7, 1994
other hand, would need more information about the property to be able to assess the
risk involved in providing a loan for construction or purchase of that office property.
Relevant Accounting Concepts

Most countries in the world have either adopted International Financial Reporting
Standards (IFRS), are in the process of doing so, or are converging their national
accounting and financial reporting systems to comply with IFRS. For example, the
Financial Accounting Standards Board (FASB) has pursued a policy of convergence
between US GAAP and IFRS since the Norwalk Agreement between FASB and the
International Accounting Standards Board (IASB) of the IFRS Foundation in 2002.2
Globally, the International Financial Reporting Standards (IFRS) affect how all
assets and liabilities, including real property interests, are appraised for financial
reporting. In its 2018 analysis of the use of IFRS standards around the world, the IFRS
Foundation states that 144 out of 166 surveyed jurisdictions require IFRS Standards
for most domestically accountable companies.
2. In 2002, the Norwalk Agreement between FASB and IASB called for convergence of US GAAP and International Financial Reporting Standards.
Certain milestone projects (including convergence of fair value measurement and leases) were agreed to, and completion of these was confirmed
by the respective boards in 2009. The original goal was to eliminate many, if not most, distinctions between the two systems by the end of 2011.
However, work continues on these and other projects. In 2005, the SEC made its first public comments about the possibility of adopting IFRS. A
“roadmap” was developed a few years later outlining the participation of the commission in international accounting standards development and
the possible acceptance of IFRS by 2014. In 2012, however, the report of the SEC work group formed in 2010 did not include a recommended
date for the transition of the US financial reporting system to incorporate IFRS.

Early on in the
development of gener- Acronyms Used in Valuation for Financial Reporting
ally accepted accounting AICPA American Institute of Certified Public Accountants
principles, including those ASC Accounting Standards Codification
relating to the accumula- FASB Financial Accounting Standards Board
tion of accounting data GAAP generally accepted accounting principles
for preparing earnings GAAS generally accepted auditing standards
statements, balance sheets, GASB Government Accounting Standards Board
and other statements for IAS International Accounting Standards
financial reporting, the IASB International Accounting Standards Board
US accounting profession IFRS International Financial Reporting Standards
elected to adopt what was IVS International Valuation Standards
considered a “conserva- IVSC International Valuation Standards Council
tive approach” when PCAOB Public Company Accounting Oversight Board
financial information SAS Statement on Auditing Standards
was publicly disclosed or SEC Securities and Exchange Commission
reported to third parties. SFAS Statement of Financial Accounting Standards
The axiom of “cost or mar- VFR Valuation for Financial Reporting
ket, whichever is lower”
characterized this ap-
proach. Under this system,
original accounting entries commonly reflected the cost of assets such as real property
rather than market value. Similar principles were applied to other tangible assets and,
customarily, to liabilities. In this context, as real estate markets change, the market value
of real property can rise while the books of account (and related financial reports) can
still record the value of real property and many other assets at original cost less book
depreciation. Because the depreciation reported in this context is customarily based on
income tax or other formula-based approaches to depreciation, significant differences
can develop between current fair market values and the figures shown on balance sheets.
In 2017, FASB developed a new accounting standard related to leases that
changed how accountants handle a company’s leases in financial reports. Effective
in 2019, Accounting Standards Codification 842: Leases required companies to start
including their leases on the balance sheet instead of as notes in the back of financial
reports. This change was made in the interest of transparency. In the past, account-
ing standards allowed lessees to categorize leases as either capital leases or operating
leases, and the latter were treated as off-balance sheet liabilities. The new lease stan-
dard eliminates the distinction between operating leases and capital leases by treating
almost all leases as liabilities that must be recorded on the lessee’s balance sheet. Real
estate owners and managers have expressed concern that the new lease standard will
result in greater use of short-term lease arrangements, which may add uncertainty to
income and asset value and influence lease and buy decisions by businesses.
Fair Value Accounting

In the United States, steps have been taken on several occasions to move to an ac-
counting system that would reflect current market values in financial reporting,
but the concept had generally been resisted until the 1990s. The emergence of one,
consistently used definition of fair value in financial accounting standards effective in
Valuation for Financial Reporting 653

2008 has helped provide authoritative guidance to valuation specialists. Valuation for
financial reporting (commonly known by the acronym VFR) is the specialized area of
appraisal work for corporate accounting and auditing purposes, often involving the
development of an opinion of the fair value of real property in which the definition
of value used in the appraisal assignment is taken from accounting standards. Fair
value measurements may not be relevant for real property valuations prepared for in-
tended uses other than financial reporting, such as property taxation, federal gift and
estate taxation, collateral valuations, divorce, or bankruptcy. Fair value accounting is
of particular importance to publicly traded entities and public entities with a strong
responsibility to third parties using independent valuations for the assets of the com-
pany rather than reliance on internal accounting or management declarations.
According to Accounting Standards Codification (ASC) 820: Fair Value Measure-
ment, valuing a nonfinancial asset such as real estate “takes into account a market
participant’s ability to generate economic benefits by using the asset in its highest
and best use or by selling it to another market participant that would use the asset in
its highest and best use.” In this context, market participants include potential buyers
of a business, not just the potential buyers of an asset on its own. Also, ASC 820 out-
lines the possible valuation premises applicable in fair value accounting: (a) the asset
is used in combination with other assets or with other assets and liabilities or (b) the
asset is used on a stand-alone basis. Generally, investment property is considered on
a stand-alone basis while assets used in the operation of a business should be consid-
ered in combination with other assets, and assumptions about the highest and best
use should be consistent for all of the assets of the group.
Figure 36.2 illustrates a framework for performing fair value assignments. The lan-
guage of fair value accounting has parallels to the language of real property appraisal as
well as some important conceptual differences that should be noted. The concepts of an
entry price and an exit price, which are implicit in the reference to an exit market in the first
step of the process, do not have obvious synonyms in real property valuation. In short,
the transaction price paid to acquire an asset is an entry price, whereas the price received
in the sale of an asset is an exit price and is considered to be the fair value of the asset.
The similarity between the concept of an exit price and commonly cited defini-
tions of market value can cause confusion in fair value assignments. For financial
reporting purposes, real property is often accounted for in the context of the busi-
ness that it serves rather than as a separate asset. Therefore, market comparisons
may have to be made of sales of a group of assets rather than the real property on its
own, depending on the valuation premise identified in Step 2 of the process shown
in Figure 36.2. For example, if a manufacturing company owns real property that in
Figure 36.2 Fair Value Framework

Step Action
1 Identify the exit market—i.e., the principal or most advantageous market.
2 Identify the valuation premise (highest and best use).
3 Determine the assumptions used by market participants.
4 Apply inputs into the valuation techniques—cost approach, market approach, and income approach.
5 Reconcile fair value.
Source: Introduction to Valuation for Financial Reporting seminar (Appraisal Institute, 2009)

some way uniquely serves its manufacturing process but would not have much value
to other industrial users, the superadequacy of the design of the real estate may not
have significant value if viewed on a stand-alone basis, but it would have value when
viewed as part of the business enterprise.
Multiple valuation techniques may be appropriate for measuring fair value (Step
4 of Figure 36.2), just as multiple approaches to value can be applied in market value
appraisals of real property. The reconciliation (Step 5) of the value indications de-
rived from the approaches applied is an essential step in the both fair value account-
ing and the more familiar process for appraising the market value of real property.
Hierarchy of Inputs
Financial reports contain the assumptions that market participants would use to
price an asset such as the risk involved in acquiring and holding the asset. In finan-
cial accounting standards, those assumptions are known as inputs. The hierarchy of
inputs is a system of characterizing the relative reliability of the assumptions that are
included in a financial statement. For example, observable inputs like the prices of
publicly traded stock are more reliable than unobservable inputs like a company’s
estimate of the value of an intangible asset such as a patent. Table 36.1 summarizes
the hierarchy of inputs—Level 1, Level 2, and Level 3.
Level 1 characteristics are observable, are quoted prices for identical assets (or
liabilities) in active markets, and are unadjusted. Level 1 inputs include (a) listed
equity securities traded in active markets such as the New York Stock Exchange and
the Nasdaq exchange, (b) on-the-run Treasury bills, notes, and bonds, and (c) many
to-be-announced government-backed securities.
Level 2 characteristics are quoted prices for similar items in active markets. They
could also be quoted prices for identical, or similar, items having no active markets.
Level 2 inputs include most US public debt, short-term cash instruments, certain
derivative products, and off-the-run Treasury bills, bonds, and notes. Adjustments to
Table 36.1 The Hierarchy of Inputs

Level
of Input Description Examples
Level 1 Quoted prices (unadjusted) in • Prices of stock in blue chip companies (e.g., a publicly traded
active markets for identical assets REIT)
Level 2 Inputs other than quoted prices • Quoted prices for similar assets in active markets
included within Level 1 that are • Quoted prices for identical or similar assets in markets that
observable for the asset, either are not active (e.g., few transactions for the asset, prices are
directly or indirectly not current, price quotations vary substantially over time or
among market makers, or little information is released publicly)
• Inputs other than quoted prices that are observable for the asset
• Valuation inputs derived principally from, or corroborated by,
observable market data by correlation or other means
Level 3 Inputs that are unobservable for • Some forms of intangibles such as patents, trademarks, trade
the asset, i.e., the reporting entity’s names, warranties, some commercial real estate in thinly
own assumptions about the inputs traded markets, and minority interests
that market participants would use
to price the asset, including risk
Source: FASB Accounting Standards Codification 820 (2018) and Introduction to Valuation for Financial Reporting seminar (Chicago: Appraisal Institute, 2009)

Level 2 inputs include considerations such as the condition and location of the asset
on the measurement date.
Level 3 characteristics are unobservable, such as a company’s own data, but the
perspective of a market participant would still be required. Level 3 inputs include
information obtained from broker quotes, management assumptions that cannot be
corroborated with observable market data, and vendor-provided prices not corrobo-
rated by market data or transactions.
Real estate valuers regularly collect information on real property and real estate
markets that qualifies as Level 2 input. Valuers are rarely able to incorporate Level
1 inputs in a valuation of real property because every parcel is unique. (Although
professional valuation standards typically require analysis of the sales history of the
subject property, the quoted prices of previous sales of the subject property are not cur-
rent and thus would be classified as a Level 2 input rather than a Level 1 input.) In fair
value accounting, Level 3 inputs are used when there is little market activity for the
asset being valued. The reasonableness of information about the property becomes an
issue for unobservable Level 3 inputs. That is, the observations of an independent ob-
server such as a valuer that would be characterized as Level 2 inputs would generally
be considered more reliable (and less subjective) than an entity’s self-reported observa-
tions, which would most likely be characterized as Level 3 inputs. In the valuation of
income-producing property using the income capitalization approach, almost all the
inputs used in that approach are Level 3 inputs, which is not an issue. However, Level
3 inputs used in the application of the sales comparison approach can be problematic.
The valuation approaches used in a fair value measurement are expected to
maximize the use of observable inputs and minimize the use of unobservable inputs.
The availability and reliability of the inputs might affect the relevance and selection
of valuation techniques, but the hierarchy of inputs affects the priority of the inputs,
not the valuation techniques.
What Services Can Appraisers Provide?

The market for valuation-related services in financial reporting is seen as a potential
growth area for real estate valuers, working with (or for) accountants, business valu-
ers, and personal property appraisers. As a significant example, corporate assets often
must be valued for inclusion on corporate financial statements. A corporate merger
or acquisition also triggers a valuation of the entire business, requiring that alloca-
tions be made for tangible and intangible assets in addition to determining if there is
any residual goodwill in the business value. Accountants often need information on
the value and depreciation of building components, both long- and short-lived items.
Debt valuation is also a growing area within valuation for financial reporting.
The 2019 “Valuation Manual” of the National Council of Real Estate Investment
Fiduciaries (NCREIF) and the Pension Real Estate Association (PREA) summarizes
common appraisal perspectives and principles for the valuation of property-level
debt as a liability, i.e., when the debt encumbers an owned asset. The measurement of
the fair value of property-level debt should consider the following principles:
• Property-level debt must be measured from the perspective of a market participant.
• Market participants include those with whom the reporting entity would likely
transact within an open market.

• A borrower’s legal interest in a mortgage does not trade to other borrowers out-
side of a real estate transaction.
• Buyers of real estate analyze the effect of leverage (new or assumed) on the prop-
erty cash flows to the net equity position.
• The income capitalization approach is the primary approach used to price the
effect of loans whereby contractual debt service payments are discounted at a
market interest rate.
• The term of the cash flow should represent what is expected to most likely occur
over the life of the note, including consideration of open prepayment periods and
extension options.
• Determining an appropriate market interest rate is highly dependent on the
observation of market participants. Market interest rates should reflect prevail-
ing lending rates used by market participants to analyze the effect of debt on a
real estate transaction, including consideration of property type, market, loan-to-
value ratio, debt service coverage, and property economics.
• Strict mathematical calculations may not reflect market behavior. Fair value mea-
surements must reflect the price that is expected to be paid by a market partici-
pant to assume the debt and should be tested against market evidence.
• The process of developing an opinion of fair value of variable-rate debt, construc-
tion loans, and unsecured fund-level debt should follow the same practices and
procedures as those followed for analysis of a reporting entity’s fixed-rate debt,
including consideration of prepayment terms and market participant behavior
for pricing similar loans.3
Other valuation services that are often categorized as valuation for financial
reporting include
• Portfolio review and valuation
• Review of internally generated values and information
• Audit assistance
• Purchase price allocation
• “Fresh start” accounting (i.e., Chapter 11 bankruptcy reorganization)
• Property tax analysis or assistance
• Capitalization rate and discount rate analysis
• Valuation model building
• Assistance in defining valuation procedures
• Valuation management
Valuation for financial reporting has long been a staple for valuers internationally,
and this work is increasingly available for valuers in the United States who have
the appropriate training and competency. For example, valuers doing this work
may need to be familiar with audit review standards and requirements or be able to
recognize business valuation procedures and how real estate value conclusions are
incorporated into an allocation of enterprise value.
3. NCREIF/PREA, Reporting Standards Handbook Volume II: Manuals, Valuation Manual (2019), 6-7.

Information Commonly Needed in Financial Reports Provided by Real Property
Valuation Specialists
• Listing and sale price information on comparable properties
• Capitalization rates or discount rates to use with cash flows
• Costs from a known cost service manual
• Depreciation rates for physical wear and tear
• Land sale prices
• Trend studies on market conditions for competitive real estate
• Demographic data demonstrating socioeconomic change patterns
• Assessment records (e.g., percentage change reports)
• Industry trends pertaining to business openings and closings
In valuation for financial reporting assignments, a valuer may be recognized as

what auditing standards consider a “specialist.” The Public Company Accounting
Oversight Board, which was created by the Sarbanes-Oxley Act of 2002, defines a spe-
cialist as “a person (or firm) possessing special skill or knowledge in a particular field
other than accounting or auditing,” according to Auditing Standards 1210: Using the
Work of a Specialist. In this context, an appraiser has the valuation knowledge and
expertise that auditors are neither required nor expected to have, such as specialized
knowledge of professional valuation standards, relevant state laws and regulations,
property characteristics and utility, trends in market conditions, and analysis of the
highest and best use of real property. Auditors generally are expected to be able to
use the audit evidence provided by a valuation specialist.
An auditor, “must document the procedures performed, evidence obtained, and
conclusions reached with respect to relevant financial statement assertions,” accord-
ing to PCAOB’s Accounting Standard 1215: Audit Documentation. “Audit documen-
tation must clearly demonstrate that the work was in fact performed. This documen-
tation requirement applies to the work of all those who participate in the engagement
as well as to the work of specialists the auditor uses as evidential matter in evaluat-
ing relevant financial statement assertions.”
When acting as a specialist in an auditing assignment, a valuer must pay particu-
lar attention to the assignment’s intended use and disclose the assignment’s purpose
in sufficient detail for the client to understand and use the valuation report as audit
evidence in internal and external audits for financial reporting purposes, which from
a valuer’s perspective is no different from an appraisal assignment for other purpos-
es. The opinion of value provided by a valuation specialist is useful to auditors and
their clients because the valuation specialist is independent and unbiased. In fact,
in certain situations the clients of auditors need to hire valuation specialists because
independence issues prohibit the auditors themselves from estimating the value of
assets that may affect their financial statements.
Under auditing standards, the qualifications of a specialist are similar to the re-
quirements of practitioners in many professional fields. These qualifications are
• Professional certification, licensing, or other recognition of competence in the field
• Reputation and standing within the community of professional peers

• Experience in the type of work under consideration
As the valuation questions that arise in the preparation of a financial report become
more complicated, the need for specialized expertise increases. As a result, valuers
with demonstrated expertise with IFRS and GAAP requirements are well-positioned
to forge ongoing working relationships with the auditors, accountants, and corpora-
tions who need valuation-related services.
Impairment of Fixed Assets

A common appraisal problem in valuation for financial reporting assignments is
the revaluation of fixed assets triggered by what is known as the “impairment test.”
According to IAS 36: Impairment of Assets, an asset is considered “impaired” if its
carrying amount exceeds the amount that could be recovered through use or sale of
the asset. The carrying amount is the value amount recorded in a company’s financial
statement for each asset within an asset group (such as buildings and infrastructure).
That value includes deductions for depreciation and impairment losses, although
depreciation in this context is accounting depreciation rather than the accumulation
of physical deterioration and functional and external obsolescence that is estimated
in the traditional valuation process for real property. The recoverable amount that is
compared to the carrying amount is either (1) fair value less selling costs, i.e., the net
selling price, or (2) value in use, whichever is higher. Again, in this context, value in use
refers to the present value of future cash flows expected to be derived from an asset or
asset complex. It is not synonymous with use value as used in real estate valuation.
For the purposes of financial reporting, assets that are deemed impaired would
require a new fair value measurement and an estimate of remaining useful life. A
revaluation of those indicators can affect the net income reported in financial state-
ments. Companies are not required to have their assets revalued at the end of each
financial reporting period, but they are required to look for indications that an im-
pairment loss is likely.
An impairment test involves a discounted cash flow analysis using a forecast in-
come statement based on the use of the existing fixed assets as of the date of apprais-
al, excluding consideration of the future growth or replacement of the assets. In an
impairment test, the DCF analysis of net operating income differs from the analysis
of profit and loss in that certain expenses are excluded from the calculations:
• Interest expense and interest income
• Other income and related expenses not derived from the use of the fixed asset
complex
• Extraordinary gains or losses
• Depreciation expenses
• Income taxes
In other words, earnings before interest, income tax, and depreciation would be
equal to net operating income, and cash flow from operations would be equal to
net income because depreciation is excluded. Note that estimating value in use for
an impairment test is not a business valuation, nor is it a technique for the direct
valuation of assets.

Professional Auditing, Accounting, and Valuation Standards
The relevant set of professional appraisal standards that apply in a particular assign-
ment for financial reporting depends on whether law, regulation, or agreement with
the client requires compliance with the Uniform Standards of Professional Appraisal
Practice (USPAP), the International Valuation Standards (IVS), or some other set of
professional standards. Valuers in the United States who are licensed or certified by
their state often must comply with USPAP because their state board requires compli-
ance with USPAP (i.e., through law). However, a valuer may be in compliance with
USPAP and IVS simultaneously.4
The 2020 edition of the International Valuation Standards includes a section
on special considerations for financial reporting: IVS 410 Development Property.
USPAP first addressed the applicability of those valuation standards in VFR assign-
ments in the frequently asked questions section published with the 2010-2011 edition
of USPAP. Global pressures will likely lead to more discussion of the potential for
convergence between USPAP, IVS, and other relevant professional valuation stan-
dards along with new discussion of valuation for financial reporting by valuation
standards-setting bodies.
The International Accounting Standards Board (IASB) is responsible for develop-
ing and maintaining the International Financial Reporting Standards, including the
fair value accounting standards that valuation specialists must understand to be able
to perform VFR assignments effectively. FASB and IASB have mutually agreed to
work toward standards that
• Are principles-based (rather than rules-based)
• Are internally consistent
• Are internationally converged
• Lead to financial reporting that provides information needed for investment,
credit, and similar decision making
A principles-based set of standards is commonly believed to require more interpreta-
tion by the user of the standards than a rules-based system. Proponents of principles-
based standards point out that a system based on a set of consistent and coherent
concepts is robust and not likely to become mired in discussion of exceptions to
specific rules, whereas critics point out the significant potential for disputes (and
litigation) when rules are not presented explicitly.
Since the Norwalk Agreement in 2002, FASB has written and updated a number
of Accounting Standards Codification (ASC) statements recognizing the importance
of market inputs when valuing tangible and intangible corporate assets (such as real
property interests) for financial reporting:
• ASC 350: Goodwill and Other Intangible Assets (Goodwill Impairment Testing)
• ASC 360: Accounting for the Impairment or Disposal of Long-Lived Assets
• ASC 805: Business Combinations (Purchase Price Allocations)
• ASC 820: Fair Value Measurements (formerly Statement on Financial Accounting
Standards 157)
4. More discussion of International Valuation Standards and professional practice and law can be found in Appendix A.

• ASC 840: Accounting for Leases (Leasehold Valuations)
• ASC 842: Leases
• ASC Topic 946: Financial Services—Investment Companies
Those standards codification continue to evolve. For example, in 2017 FASB issued
Update 2017-01: Business Combinations: Clarifying the Definition of a Business to
clarify ASC 805: Business Combinations (Purchase Price Allocation). The update ad-
dressed criticism of ASC 805 that the definition of a business was applied too broadly
in that standard, creating potential ambiguity between the purchase of a business
and the acquisition of an asset. The update spells out more plainly the set of charac-
teristics required for an entity to be classified as a business in the context of a busi-
ness combination.5
Appraisers engaged in valuation for financial reporting activities should keep
abreast of evolving financial accounting standards. The organizations listed in Table
36.2 publish information on new standards and, along with professional journals cov-
ering accounting issues, they are the best sources of information about the conver-
gence of standards internationally.
In the same manner that US and global valuation and accounting standards are
converging, US generally accepted auditing standards (GAAS) are converging with
their international counterpart. The American Institute of Certified Public Accoun-
tants recently completed its Clarity Project in which US generally accepted auditing
standards were redrafted and recodified. AICPA’s new statements on auditing stan-
dards are principles-based, mirroring the trend in the convergence of professional
accounting and valuation standards.
5. Financial Accounting Standards Board, “Accounting Standards Update 2017-01, Business Combinations (Topic 805): Clarifying the Definition of
a Business,” FASB in Focus (January 5, 2017).

Table 36.2 Organization Involved in Accounting, Auditing, and Valuation Standards
Entity Description Relevant Rules Website
American Institute The largest US national • SAS 73: Using the Work of a www.aicpa.org
of Certified Public professional association Specialist
Accountants (AICPA) for CPAs • SAS 101: Auditing Fair Value
Measurements and Disclosures
The Appraisal A US nonprofit educational • Uniform Standards of www.appraisalfoundation.org
Foundation organization dedicated to the Professional Appraisal Practice
advancement of (USPAP)
professional valuation
CFA Institute The largest global • Global Investment Performance www.cfainstitute.org
nonprofit organization Standards (GIPS)
of investment professionals
Financial A private nonprofit organization, • ASC 840: Accounting for Leases www.fasb.org
Accounting not a government agency; the (SFAS 98)
Standards primary US standards-setting • ASC 805: Business Combinations
Board (FASB) organization for developing (SFAS 141(R))
generally accepted accounting • ASC 350: Goodwill and Other
principles; subject to Intangible Assets (SFAS 142)
oversight by the Financial
Accounting Foundation • ASC 360: Accounting for
(FAF) Impairment or Disposal of
Long-Lived Assets (SPAS 144)
• ASC 820: Fair
Value Measurements
(SFAS 157)
IFRS Foundation A private nonprofit standards- • International Financial Reporting www.ifrs.org
setting organization responsible Standards (IFRS)
for developing and amending
international standards for
financial reporting
International Standards A private nonprofit organization • International Valuation Standards www.ivsc.org
Valuation Council established as an international (IVS)
(IVSC) valuation standards-setting body
National Council A private nonprofit trade • NCREIF/PREA Reporting www.ncreif.org
for Real Estate association that provides Standards
Investment investment performance
Fiduciaries (NCREIF) indices and data for US
commercial properties
Public Company A nonprofit corporation • Sarbanes-Oxley Act of 2002 www.pcaob.org
Accounting Oversight established by Congress
Board (PCAOB) to oversee the audits of
public companies in order
to protect the interests of
investors and further the
public interest in the preparation
of informative, accurate, and
independent audit reports
Securities and An independent US regulatory • Securities Act of 1933 www.sec.gov
Exchange agency with the statutory • Securities Exchange Act of 1934
Commission (SEC) authority to establish financial • Trust Indenture Act of 1939
accounting and reporting
standards for publicity held • Investment Company Act of 1940
companies • Investment Advisors Act of 1940

• Sarbanes-Oxley Act of 2002
• Credit Rating Agency Reform Act
of 2006
Note that the Standards of Professional Practice of the Appraisal Institute are composed of the Certification Standard of the Appraisal Institute and (a)
the Uniform Standards of Professional Appraisal Practice or (b) the International Valuation Standards and applicable national standards.

Valuation of Real Property 37
with Related Non-realty Items
The primary benefit of private real estate ownership is its ability to house human
activities. For example, unimproved land is used for raw materials, agriculture,
recreation, and open space. Improved properties provide shelter for households or
businesses. Income to real property is generally in the form of rent (which is, in es-
sence, a payment for the right to use property) or royalties. Whenever the income to a
property includes payments for goods or services other than real property rents, the
property potentially includes non-real property assets that need to be addressed ap-
propriately. The presence of services that generate income over and above rent on the
real property may create intangible property value. Often, however, the net income
attributable to those services is viewed as being only incidental, and any incremental
value created is considered to be inconsequential. As the proportion of income attrib-
utable to non-real estate sources increases, the potential for the property to include
measurable intangible assets also rises.
Certain types of real estate improvements are designed and constructed solely for
use in a business operation. Examples include a car wash, hotel, or a senior care facility
where the design is specific to that business operation. Often, this type of real property
is sold together with the business. In real property valuation, the business entity is re-
ferred to as a going concern, which can include real property, tangible personal property
(such as furniture, fixtures, and equipment), and intangible assets (such as franchise
agreements, other business contracts, and business goodwill). For some appraisals, an
allocation or separate valuation of the real property component may be needed.
Standards Rule 1-4(g) of the Uniform Standards of Professional Appraisal Prac-
tice states, “When personal property, trade fixtures, or intangible assets are included
in the appraisal, the appraiser must analyze the effect on value of such non-real
property items.” Those standards do not require a specific allocation of the value
opinion between realty and non-realty components or a separate valuation of those
components. However, the scope of work for appraisals prepared for ad valorem
taxation, eminent domain, financial reporting, mortgage lending, and other purposes
may encompass an allocation or a separate valuation of the real property component.
For some property types like hotels, car washes, marinas, and assisted-living facili-
ties, the real property rarely sells independently of personal property and intangible
property. In those cases, establishing a reasonable allocation of the value opinion
among the realty and non-realty components can be challenging.
If a separate value in exchange opinion is provided for a non-realty component,
the appraiser needs to consider the conditions of the value definition being used. For
example, market value presumes a hypothetical sale of the asset being valued under
certain stated conditions. The analyses and conclusion of value for the component
must be consistent with the value definition. On the other hand, allocation is usually
a matter of considering how much the component contributes to the larger asset—for
example, how much it contributes to the going concern. The allocated amount does
not necessarily represent a value in exchange. More likely, it represents a contributo-
ry value of that component. Furthermore, when a separate value in exchange opinion
is developed for each component, the sum of those values may be more (or less) than
the value of the whole as if sold together. However, in the case of allocation, the sum
of the amounts allocated to each component will equal the value of the whole.
Asset Classes and Transaction Types

Appraisal practice identifies three general classes of assets:
1. Real property
2. Personal property (tangible and intangible)
3. Financial assets
Two ways to visualize the different types of assets are shown in Figure 37.1.
Tangible assets include real property and physical personal property (for ex-
ample, furniture, fixtures, and equipment). Personal property includes all tangible
property not classified as real property and intangible (nonphysical) assets such as
contracts, franchises, trademarks, copyrights, and goodwill items such as a valu-
able trade name and a trained workforce. Businesses also generally require working
capital and other financial assets, which are best placed in a separate category called
financial assets. Financial assets include cash and other assets the business intends to
eventually convert to cash. A graphic representation of the components of the total
assets of a business is shown in Figure 37.2.
Figure 37.1 Different Perspectives on the Types of Assets
Types of Assets Types of Assets
Real Personal Financial Assets Tangible Intangible Financial Assets
Tangible Real
Intangible Personal

Figure 37.2 Components of the Total Assets of a Business in an Asset-Based Transaction
Total assets of
the business
Intangible Financial assets and

Tangible property
personal property working capital
Franchises and
Real property Cash
other contracts
Tangible Patent, trademark, Marketable

personal property copyright securities
Assembled Accounts
workforce receivable
Supplies and
Trade name
inventory
Residual
intangible assets*
Note: Some appraisers consider supplies and inventory to be a subset of tangible personal property rather than a financial asset, which is also
acceptable In any case, the appraisal report must make it clear to the reader what assets are included in the valuation and how they are allocated.
* The difference between the value of the total assets of the business and the contributory value of all other identified assets.”
Appraiser Competence
Without specialized education, real property appraisers are not generally competent to provide an opinion of the
value of a business itself. Valuation of a business entity requires an analysis of liabilities as well as assets, and
must consider the organizational structure, capital structure, control, basis and income taxes, and other issues.
Business valuation and personal property valuation are distinct segments of the valuation profession, and those
disciplines require substantial specialized education and experience that most real property appraisers do not have.
Before accepting an appraisal or appraisal review assignment, an appraiser must decide that he or she
has or can acquire the expertise to complete the assignment competently, and the appraiser must notify the
client of any actions taken to acquire competency. For certain assignments, it may be necessary for a real
property appraiser to collaborate with a personal property appraiser, a business appraiser, or both.
With adequate training and experience, a real property appraiser may become competent in valuing busi-
ness entities that are primarily real property and also include tangible personal property and intangible prop-
erty. However, in valuing such a property, a real property appraiser is generally only valuing the asset-based
entity that could be bought and sold by businesses. Even when an appraisal assignment involves valuing only
real property, any allocation is an appraisal, according to professional standards. In making an allocation,
an appraiser must adhere to applicable professional standards (e.g., Standard 1 of USPAP for real property,
Standard 7 for personal property, and Standard 9 for intangible assets or the various asset standards in the
International Valuation Standards) and must comply with any standards rules related to competency (e.g.,
the Competency Rule in USPAP and Ethical Rule 1-3 in the Code of Professional Ethics of the Appraisal
Institute). Tax courts have often stated that professional certification and designation programs are helpful
in delineating whether an appraiser meets the knowledge and expertise of USPAP and the Federal Rules of
Evidence, even if those criteria are not dispositive of a professional’s competence.
Valuation of Real Property with Related Non-realty Items 665

Sales of businesses can be classified in two general transaction types: (1) entity-
based transactions and (2) asset-based transactions. In an entity-based transaction,
the buyer acquires the actual business entity of the seller through a purchase of the
stock, partnership interests, membership interests, or other specified interests, de-
pending on the form of the business. In an asset-based transaction, the buyer acquires
only the assets of the business but does not acquire the business entity itself. Say, for
example, a hotel is owned by Jones Hotel Inc. and is the primary asset of that busi-
ness. In an entity-based transaction, the buyer would acquire the ownership interests
through stock certificates in Jones Hotel Inc. and would assume control of that com-
pany. The buyer would not only acquire the hotel and any other assets of Jones Hotel
Inc. but also any liabilities of the company. In an asset-based transaction, the buyer
would acquire only assets of Jones Hotel Inc., such as the real property, the personal
property, certain financial assets (when appropriate), and perhaps certain intangible
assets. The business entity, Jones Hotel Inc., would remain in the hands of the seller.
For small businesses, asset-based transactions are often preferred because of simplic-
ity, reduced legal exposure, and potential tax advantages.
Regardless of the form of a sale, an appraiser must take care to identify which
assets were included in the transaction. For some property types, it is common for
an asset-based transaction to include real property, related personal property (such
as furniture, fixtures, and equipment, commonly referred to by the acronym FF&E),
and certain intangible assets, but to exclude the financial assets. However, that is not
always the case. In some asset-based sales contracts, a mechanism is set up for the
transfer of certain financial assets like accounts receivable or inventory, but the price
of those items may or may not be included in the stated purchase price. When this is
the case, it poses an additional requirement for the appraiser analyzing comparable
sales to determine which assets were included in the transfer. The verification process
of comparable sales should also focus on the presence of any financial assets that
were included. This is critical to ensure that proper rates and ratios are developed.
The Going-Concern Premise

Business appraisers generally consider the value of a business under both a going-
concern premise and a liquidation premise. Under the going-concern premise, the
business is assumed to continue operating indefinitely. Under the liquidation prem-
ise, it is assumed that the business operation is closed and the assets are sold off. The
premise that results in the higher value indication is used for the development of the
final value opinion. The appraiser’s determination of the appropriate premise is criti-
cal in determining the proper appraisal techniques, in selecting comparables, and in
making an appropriate allocation of value to the various asset classes.
If the income generated by the business is less than the amount required to sup-
port the value of the assets, liquidation (closing the business and selling the assets) is
the best course of action because it results in the highest value. Unless a forced liqui-
dation is specifically assumed, the liquidation premise assumes an orderly disposi-
tion without atypical seller motivation or a limited marketing period.1
Suppose, for example, that an appraiser is asked to value a car wash operating
under a franchise agreement with a large national chain. The building has a distinc-
1. A value indication under the liquidation premise is not commensurate with liquidation value as that term is used in real estate appraisal.

tive design and an upgraded facade required by the franchisor, and the equipment
includes some specialized detailing equipment to provide services that are required
by the franchise agreement. If the operation is highly profitable, the appraiser may
conclude that continued operation of the business will produce the highest value. In
that case, the proper allocation of value to the real property and personal property
could be as high as the physically depreciated replacement cost (because the facade
upgrades and specialized equipment contribute to the value of the tangible assets as
a part of the going concern), and the franchise contract could be viewed as a valu-
able intangible asset. Alternatively, the appraiser may conclude that a higher value
may be realized by closing the franchised business operation and reducing costs by
eliminating franchise fees and cutting staff and other expenses related to the special
services. In that case, the proper allocation to real property may be lower because the
special facade required by the franchise may not contribute to value as an overim-
provement to the real estate, and the proper allocation of value to the franchise con-
tract may be zero. A third alternative is that the appraiser may conclude that demoli-
tion or conversion to a different use altogether is the highest and best use, in which
case the allocation to tangible personal property may be limited to salvage value, and
there may be no allocation to intangible assets.
Another important concept under the going-concern premise is that the sum of the
independently development market values of the parts may not be equal to the value of
the whole. It is generally improper to value the real property, personal property, and in-
tangible property separately from the going concern and simply sum up those individ-
ual values to arrive at the value of the whole property under the going-concern premise.
When a team of appraisers (e.g., a real property appraiser, a personal property ap-
praiser, and a business appraiser) work together on an assignment, the appraisers must
ensure that the valuation premises and income and expense projections are accounted
for consistently in their work to avoid double-counting income or expense items.

For real estate-intensive business properties, all three valuation approaches may be
applicable. However, depending on the assignment, certain approaches could be less
applicable to some of the asset classes, and certain approaches may be less helpful in
determining an appropriate allocation of the final value opinion. These scope of work
decisions are made by the appraiser in determining a solution to the client’s problem.
The Cost Approach

In situations where the cost approach can be developed reliably, it can be useful in de-
termining the appropriate allocation of value to the different asset classes. A common
strategy is to use the cost approach to value only the tangible asset classes. The value
indication from the cost approach can then be compared to value indications from the
sales comparison and income capitalization approaches. If those approaches indicate
a higher value than the cost approach for only the real estate and tangible personal
property, the difference may be an indication of the value of the intangible assets.
In some circumstances, it may also be appropriate to allocate value to certain
intangible assets based on replacement cost. For example, the appropriate value allo-
cation to an assembled workforce in a particular case may be the cost of replacing the
workforce, including employment agency fees, advertising costs, interview expenses,

and payroll expenses during any unproductive training period. It is important to
keep in mind that, as with real property, the cost of an intangible asset does not nec-
essarily equal value. However, cost may be an appropriate basis for an allocation.
Table 37.1 illustrates the application of the cost approach to value tangible assets
alone. In cases where intangible assets can be reasonably valued based on replace-
ment cost, it may be possible to include a column for intangible assets and develop a
value indication for the total property by the cost approach.
Table 37.1 Application of the Cost Approach Addressing Tangible Assets Only
Real Property Personal Property Total Tangible Assets
Direct and indirect cost $2,500,000 $210,000 $2,710,000
Entrepreneurial incentive $250,000 — $250,000
Total replacement cost $2,750,000 $210,000 $2,960,000
Depreciation
Physical deterioration - $600,000 - $42,000 - $642,000
Functional obsolescence - $200,000 $0 - $200,000
External obsolescence $0 $0 $0
Total depreciation - $800,000 - $42,000 - $842,000
Depreciated value of improvements $1,950,000 $168,000 $2,118,000
Land value $600,000 — $600,000
Value indication by the cost approach $2,550,000 $168,000 $2,718,000
An important consideration for the cost approach is that allocating all the entrepre-
neurial incentive attributable to the property to only the real property may not be ap-
propriate. The portion of entrepreneurial incentive relating to the development of the
real property should be allocated to that asset class, but the portion of entrepreneurial
incentive relating to the personal property and to establishing the business (e.g., legal,
marketing, and staffing expenses) may be more appropriately allocated to those assets.
Supportable estimates for all forms of depreciation are critical to the develop-
ment of a reliable cost approach. Properties that are tied to business operations tend
to be specialized constructions and can be more susceptible to functional obsoles-
cence than, say, a simple office, warehouse, or retail building. If there is any oversup-
ply of a particular property type in a given market, it is likely that existing properties
of that type exhibit external obsolescence due to market conditions.
The Sales Comparison Approach

For certain property types, real property rarely sells independently from personal
property and intangible property. However, in some cases, it may be possible to al-
locate the prices of comparable sales between real property, personal property, and
intangible property. Also, it could be reasonable to address each asset class separately
in the sales comparison approach or to address real property on its own. One con-
sideration could be the allocation agreed to by the buyer and seller in a transaction.
However, caution is necessary because those allocations may be based on income
tax issues or other considerations and may not reasonably reflect the actual value
contribution of the various assets. Other sources of allocation information could be
industry standards or interviews with market participants.

For property types where real property rarely sells independently from the
personal property and intangible property, comparable sale prices often cannot be
reliably allocated to the various asset classes. In those cases, the sales comparison ap-
proach may only provide a value indication for the total property without allocation.
In a sales comparison analysis without allocation, the total price of the comparable
sales can be analyzed to provide a value indication for the subject property in total,
including all the asset types. Whether quantitative adjustments or qualitative analy-
ses are used, the analyses must consider differences in personal property and intan-
gible property as well as differences in real estate characteristics. It is critical that the
appraiser identify what assets were included in each comparable sale.
The Income Capitalization Approach

Income capitalization methods used by appraisers to value properties with personal
property and intangible property components vary widely. Some methods address
only the total value of the property without allocation to the asset classes. Others are
more detailed and break down income between the various assets or asset classes.
As with all income property valuation, the selection of the appropriate method or
methods is based on three considerations:
1. The capitalization method (or methods) used by market participants. If the goal
of the valuation is to predict what would have been paid for the property if it had
been exposed on the open market, it is preferable to perform calculations in the
way typical buyers and sellers do.
2. What market data is available. Appraisers should avoid applying techniques for
which the income and expense projections or capitalization rates cannot be sup-
ported with market evidence. Depending on the scope of work, a less detailed
method may be preferable to a more detailed method if it can be better supported
by market data.
3. The method selected must be adequately detailed to solve the problem. For
example, if the pattern of income projected for a particular property is highly ir-
regular, an appraiser may decide that discounted cash flow analysis is necessary
even though direct capitalization is more commonly used by market participants
and direct capitalization rate data is more readily available.
Selecting the appropriate capitalization method for a property with personal
property and intangible property components requires judgment. For some prop-
erty types, data is more plentiful for overall capitalization methods. However, if the
scope of work includes an allocation of the value opinion between the asset classes or
Appraisal Institute Resources for Further Research on the Debate

Numerous court decisions have been made in property tax cases in various states, and research may be
performed on those cases and on the ongoing debate about allocation of assets using a variety of recom-
mended resources:
• The Y. T. and Louise Lee Lum Library of the Appraisal Institute
• Appraisal Institute publications such as A Business Enterprise Value Anthology (2001) and A Business
Enterprise Value Anthology, 2nd ed. (2011), which include citations of relevant court decisions
• Articles in The Appraisal Journal

the value of real property only, judgments on a breakdown of income between asset
classes may be necessary to apply the appropriate rates to the components.
Valuation Techniques
Intangible assets are inherent in the operation of some property types. In those cases,
appraisers do not ask whether intangibles exist, but rather how the intangibles should
be measured. The same is true of personal property. The challenge of accounting for the
value of non-realty assets is complicated by the variety of property types and markets in
which they are traded. For example, intangible assets inherent in the operation of sports
stadiums may be treated differently by market participants than the manner in which
market participants treat intangible assets inherent in convenience stores. Intangible as-
sets inherent in health care properties may be treated differently by buyers and sellers in
that market than by buyers and sellers of regional malls. How market participants treat
these assets may change over time and may be an unresolved issue, and various meth-
ods have been developed for appraisers to consider. One of the most reliable procedures
for appraisers to follow is to interview active buyers of a specific property type (that is
the same as the subject property) to determine what the actual market makers believe
they are purchasing and how and why they make value allocations. Because all of the
methods are subject to criticism, the professional appraiser should exercise judgment as
to which method, or combination of reconciled methods, provides a credible conclusion.
The appropriate method of valuing or allocating intangible assets has been
highly controversial among real property appraisers. It is important for all involved
in this form of valuation work to understand the history and intensity of the debate
and to understand the various alternative methodologies regarding how intangible
assets should be accounted for in the valuation process.
Given the complexity of the issues and intensity of the controversy, generaliza-
tions can be dangerous. Nevertheless, several basic approaches can be identified that
are being used in the marketplace, and those approaches are described below.
The Cost Approach

The cost approach is one method of allocation that is straightforward and eliminates
the need to address tangible and intangible personalty. Many appraisers use the ap-
proach as a check to see if an indication of intangibles exists in a going concern in ad-
dition to using the approach as support along with another method or methods. The
cost approach is particularly useful in situations where sales of total assets of going
concerns are the only sales available. The amount and type of depreciation existing in
the asset play a role in the effectiveness of this approach. When significant deprecia-
tion exists, the approach may have less applicability.
The cost approach does not provide an indication of value for certain assets, such
as intangibles, unless specifically supplemented to do so. Thus, the value indication
of the cost approach is often compared with the value indications from the sales com-
parison approach and income capitalization approach when only sales of the total
assets of the going concern are available to the appraiser. The premise is that the cost
approach provides an indication of value of the fee simple interest in the real estate
(and possibly non-realty personalty also) whereas the other two approaches may
provide value indications for the total assets of the going concern. Therefore, the dif-
ference between the reconciled value using the income capitalization and sales com-

parison approaches for the total assets of the going concern and the cost approach for
the fee simple interest in the real estate plus other tangible assets may represent the
intangible business value. An example of the approach is shown in Figure 37.3.
Figure 37.3 Example of Cost Approach Application

A six-year-old, 90-bed assisted-living facility has an estimated market value of the going concern of $6,750,000. Land
value has been estimated at $900,000, and the depreciated value of the improvements is estimated at $5,200,000.
The estimated value of FF&E is $450,000.
What is the allocated market value of the intangible assets?
Market Value of the Going Concern $6,750,000
Less Depreciated Value of the Improvements - $5,200,000
Less Land Value - $900,000
Less FF&E - $450,000
Intangible Assets $200,000
Overall Capitalization without Allocation to Asset Classes

For some real estate-intensive businesses, market participants commonly estimate
net income in a format similar to other real estate investments including deductions
for detached management and adequate reserves to handle periodic replacement of
furniture, fixtures, and equipment. For some other business types, transactions are
based on other measures of income such as
• gross revenue
• gross profit
• seller’s discretionary earnings (SDE)
• earnings before interest, taxes, depreciation, and amortization (EBITDA)
• earnings before interest and taxes (EBIT)
• net earnings
In some markets, EBITDA calculations do not typically include deductions for man-
agement fees, real estate rent, or returns/reserves for personal property, so appraisers
clarify by using the acronyms EBITDAR and EBITDARM, where R refers to rent and
M refers to management fees.
Table 37.2 is an example of how various multipliers or capitalization rates can
be extracted from a comparable sale by comparing income at a particular level to the
overall sale price including real property, tangible personal property, and intangible
personal property. If the multipliers or capitalization rates extracted from comparable
sales are analyzed and appropriate multipliers or capitalization rates are applied
consistently to the subject property’s projected income, the resulting value indication
will relate to the subject property’s overall value including real property, tangible per-
sonal property, and intangible personal property. Consistency is necessary to result in
a credible conclusion. When extracting multipliers or capitalization rates from com-
parables and applying them to the subject, the income used in the calculation must
be calculated consistently and the price/value used in the calculation must relate to
a consistent set of assets. As with all capitalization problems, the analysis may be
strengthened by using multipliers or rates based on more than one level of income.

Table 37.2 Overall Capitalization Analysis (without Allocation)
Sale Price (real property, tangible personal property, and intangible personal property): $2,900,000
Income Rate/Factor Type

Gross revenue $880,000 3.30 Revenue multiplier
Cost of goods sold - $130,000
Gross profit $750,000 3.87 Gross profit multiplier
Expenses:
Payroll (excluding owner) - $180,000
Franchise fees - $35,000
Other operating expenses - $110,000
Property tax and insurance - $40,000
SDE (seller’s discretionary earnings) $385,000 7.53 SDE multiplier
Market payroll for owner’s labor - $30,000
EBITDA/EBITDARM $355,000 8.17 EBITDA multiplier
Management fee - $44,000
Replacement reserves (including FF&E) - $21,000
Net operating income $290,000 0.10 Overall capitalization rate
In some markets for certain property types, overall capitalization without alloca-
tion to the various asset classes is the technique that is used most often and is most
commonly recognized by market participants. Other possible advantages are that
the data necessary to make the calculations is relatively plentiful and the calculations
themselves are relatively simple. The disadvantage is that the resulting value indica-
tion is not broken down by asset class. Therefore, if the scope of work calls for an
allocation or for a value opinion for real property only, an appraiser must use some
method other than the income capitalization approach to make the allocation.
Capitalization with Allocation to the Asset Classes

When the scope of work calls for the appraisal to include an allocation of the market
value of the going concern, it may be appropriate to apply the income capitalization
approach with income allocated to the various asset classes and with a separate capi-
talization rate or multiplier assigned to each income component. When real property
is included as a fee simple estate, the appropriate income allocation to real property is
generally considered to be equal to absolute net market rent. The allocation to personal
property must account for both return on and return of investment for that asset class,
which is more than just a replacement reserve that covers only return on investment.
Excess Earnings Method

In the excess earnings method, which was developed by the US Department of the
Treasury in the 1920s, income is first allocated to the tangible assets, and any residual
income is allocated to intangible assets. Typically, no deduction is made for manage-
ment fees, so the EBITDA attributable to intangible assets assumes the business is
managed by the owner. However, a variation used by some appraisers for certain
property types includes a management fee, so EBITDA becomes a net amount for
a passive business owner. Table 37.3 illustrates an income statement for the excess
earnings method, both with and without a deduction for a management fee.

Table 37.3 Overall Capitalization Analysis (with Allocation)
Without Deduction With Deduction
for Management Fee for Management Fee
Gross revenue $880,000 $880,000
Cost of goods sold - $130,000 - $130,000
Gross profit $750,000 $750,000
Expenses:
Payroll - $210,000 - $210,000
Franchise fees - $35,000 - $35,000
Other operating expenses - $110,000 - $110,000
Property tax and insurance - $40,000 - $40,000
EBITDAR/EBITDARM $355,000 $355,000
Management fee - $44,000
Real property rent - $230,000 - $230,000
Return on and return of personal property - $31,778 - $31,778
EBITDA (income to intangible property) $93,222 $49,222
Ideally, the estimate of real estate rent in the excess earnings method is based on
analysis of direct rent comparables. However, for some property types, data of that
type is scarce or nonexistent. In those cases, the rent must be estimated in some other
way, such as
• Multiplying or dividing the depreciated cost from the cost approach by a lease
constant (capitalization rate or multiplier as appropriate)
• Analyzing comparable rents for similar property types (e.g., apartment rents for
assisted-living facilities, big-box retail rents for a fitness club or bowling center)
and making appropriate adjustments
• Applying an appropriate rent-to-revenue ratio based on data from an industry
association study, interviews with market participants, or other sources
Each of the alternative methods of estimating real estate rent has potential weakness-
es. Nevertheless, by using more than one method, appraisers can make reasonably
supported conclusions.
The allocation of income to the personal property in the excess earnings method
can also be thought of as rent and must be adequate to provide a return on and return
of investment in personal property. Replacement reserves are not an adequate income
allocation for personal property in the excess earnings method. A typical replacement
reserve provides return of investment but not return on investment. For example,
consider a property that has personal property with a replacement cost of $210,000
and a useful life of 10 years. If the personal property is an average of two years old,
the value might be estimated at about $168,000 (8/10 of $210,000, rounded). A simple
straight-line replacement reserve could be estimated at $21,000 per year ($210,000/10
years). However, an investor would not be attracted to purchase the personal prop-
erty for $168,000 if the potential income was only $21,000 per year for eight years.
In most cases, rent comparables for furniture and equipment are not available, so
the rent is calculated based on cost. One common method is to multiply the depreci-
ated cost of the personal property from the cost approach by an appropriate lease

constant (i.e., a capitalization rate). If the personal property has no salvage value at
the end of its useful life, the lease constant is equal to a loan constant for the remain-
ing life of the personal property at an appropriate discount rate or interest rate. For
example, if the personal property has an 8-year remaining useful life and the ap-
propriate discount rate is 10.25%, the appropriate annual capitalization rate is about
18.92% (0.189153 partial payment factor for 8 periods at 10.25% per period). If the val-
ue of the personal property is $168,000, income attributable to the personal property
could be estimated at $31,778 ($168,000 × 0.189153).2
The final step in the excess earnings method is to apply an appropriate capitaliza-
tion rate to each of the component asset classes. Table 37.4 illustrates an example of
capitalization relating to the sample income statement in Table 37.3. A simple table
can help keep the calculation consistent. Of course, if the excess earnings attributable
to intangible property are calculated after deducting a management fee, the appro-
priate capitalization rate will be lower than it would be if no deduction is made for
management fees. The value of the property does not change based on the method
of calculating income or on the method of capitalization. The key is to extract capi-
talization rates from comparable data and apply them to the subject property using
consistent treatment of management fees and any other expenses.
In assigning capitalization rates to the asset classes, the appropriate capitalization
rate for personal property is generally considered to be higher than the capitalization
rate for the real property. Land does not depreciate and real estate improvements
generally have a longer life than personal property, so real property income is more
durable. The appropriate capitalization rate for intangible property is generally
higher than the real property capitalization rate because income to the intangible as-
sets is much riskier. The overall capitalization rate for the total going concern should
also be checked for reasonableness.
Table 37.4 Capitalization in Excess Earnings Method

Example without Deduction for Management Fee
Income Capitalization Rate Value
Real property $230,000 0.0950 $2,421,000
Personal property $31,778 0.1892 $168,000
Intangible property $93,222 0.3000 $311,000
Total as a going concern $355,000 0.1224 $2,900,000
Example with Deduction for Management Fee
Income Capitalization Rate Value
Real property $230,000 0.0950 $2,421,000
Personal property $31,778 0.1892 $168,000
Intangible property $49,222 0.1583 $311,000
Total as a going concern $311,000 0.1072 $2,900,000
2. Another method used by many business appraisers to calculate income to the personal property is to figure return on investment based on a
discount or interest rate applied to the current value of the personal property, and add the return of investment calculated as a replacement
reserve. For the example used here, the total would be $168,000 × 10.25% = $17,220 (return on) plus $210,000/10 years = $21,000 (return
of), for a total of $38,220. The income allocated to personal property on that basis is higher because the calculation does not account for the
time value of money. Nevertheless, this and other methods are acceptable as long as the calculation is consistent in extracting capitalization
rates from comparable sales and applying them to the subject property.

Ideally, the capitalization rate applied to real property income would be extracted
from comparable sales of real property only. However, for some property types, real
property rarely sells independently from personal property and intangible property,
so direct capitalization comparables are scarce. In those cases, it may be possible to
extract rates from sales of going concerns using a residual method. Another consid-
eration is the use of capitalization rates for other property types that have similar
income pattern and risk characteristics. If adequate support is available, it may also
be possible to calculate a real estate capitalization rate using a band-of-investment
technique or a property model formula. When data is scarce, use of more than one
method of determining the capitalization rate can strengthen the analysis.
The capitalization rate for the intangible property should also be based on com-
parable data, to the extent possible. As with real property, it may be possible to use
a residual technique to extract rates from comparable sales of going concerns when
sales of intangibles only are not available. For many types of businesses, comparable
data is available from vendors who compile that data specifically for use by apprais-
ers, brokers, and others. It is also helpful and important to interview business brokers
and other market participants.
Parsing Income Method

In cases where the assignment is to value real property only, some appraisers use the
parsing income method, which is a variant of the excess earnings method of business
valuation. The difference in the parsing income method is that real property income
is calculated as the residual rather than intangible property income. Table 37.5 illus-
trates two common formats. The intangible assets must be identified, and an income
allocation assigned to each. The income allocation is based on either (a) estimating
the amount the intangible asset contributes to income or reduces expense or (b) esti-
Table 37.5 The Parsing Income Method: Real Estate as a Residual

Without Deduction With Deduction
for Financial Assets for Financial Assets
Gross Revenue $880,000 $880,000
Cost of Goods Sold - $130,000 - $130,000
Gross Profit $750,000 $750,000
Expenses:
Payroll - $210,000 - $210,000
Franchise Fees - $35,000 - $35,000
Other Operating Expenses - $110,000 - $110,000
Property Tax & Insurance - $40,000 - $40,000
EBITDAR/EBITDARM $355,000 $355,000
Management Fee - $44,000 - $44,000
Income to Personal Property ($168,000 x 0.1892) - $31,778 - $31,778
Income to Intangible Property - $49,222 - $49,222
Income to Financial Assets ($90,000 x 0.04) n/a - $3,600
Residual Income (Rent) to Real Property $230,000 $226,400
Real Property Capitalization Rate 0.0950 0.0935
Real Property Value Indication (rounded) $2,421,000 $2,421,000

mating the value of the intangible asset by some other method and multiplying by an
appropriate capitalization rate. In some models, deductions are also made for returns
to financial assets. Again, consistency in extraction from market data and application
to the subject property is key. Consistency must be maintained both in how income is
calculated for the numerator in the capitalization rate calculation and in what assets
are included in the denominator for the calculation. The valuation of a going concern
that is centered on a real estate component may not include financial assets. Often,
financial assets may not be included in the transfer of these properties. Table 37.5 il-
lustrates the analysis with and without financial assets included.
In real estate appraisals, it is accepted that land has a priority claim on the value
of improved real property. The total value of improved real property is allocated
first to the land at its highest and best use, and the improvements are allocated the
remainder. In a similar way, business appraisers generally view the tangible assets as
having a priority claim on the value of the going concern. Therefore, when treating
real property as a residual, some of the same caution is necessary as would be true for
a land residual technique in a real estate appraisal. The appraiser must use care that,
in allocating income to the intangible property, the allocation is limited to the amount
the intangible assets actually contribute to the income of the entire going concern.
The parsing income method is consistent with the going-concern premise. The ap-
plication of the method starts with an allocation of income and expenses to each of the
asset classes, which is known as “contributory asset charges” in the business valuation
community. Once the net income to each asset class is identified, it can then be capital-
ized into an indication of value by dividing by an appropriate capitalization rate or
multiplying by an appropriate factor for each asset class. Alternatively, as shown in
Figure 37.5, when only the value of the real estate is being sought, then capitalizing
the income net of the contributory asset charges will accomplish this objective.
In the use of the parsing income method, it is critical for appraisers to ensure that
any allocation of the income and expenses correctly identifies the contribution of the
income to the total assets from tangible and intangible personalty. If the allocation is
not done properly, it is unlikely that the residual value for any asset class will be cor-
rect. Critics state that this methodology is flawed because the identification of an ap-
propriate capitalization rate to convert the residual income to different asset classes
can be difficult. This method has also been criticized for the deductions applied for a
return on the various components of the going concern, which create an opportunity
for double-counting unless caution is exercised by an appraiser.
The Management Fee Approach

The management fee approach has been used by some appraisers as a variant of
overall capitalization analysis. From that viewpoint, deduction of franchise fees and
management fees accounts for returns to the business, and replacement reserves ac-
count for future replacement of furniture, fixtures, and equipment. This approach of
valuing tangible assets exclusive of intangible assets is based on the theory that once
the revenue attributable to intangible assets is deducted, all other remaining income
is attributable to the real property and other tangible assets. In other words, this
approach involves the calculation of a residual, in much the same way that residu-
als are calculated in land residual analysis or in the various residual calculations in
the income capitalization approach. The management fee approach is similar to the

business valuation approach called relief of royalty, where the value of the intangible
property is equal to the value of the royalty payments from which the company is
relieved by virtue of its ownership of the asset. Critics of this method assert that the
value of intangible assets and rights cannot be removed by merely deducting the
related expenses from the income stream to be capitalized; allowing a deduction for
the associated expense does not allow for a return on the capital expenditure. How-
ever, proponents of this approach counter that a return on capital is implicit in the
management fee or relief of royalty. These management fees enable the provider to
operate a profitable business and obtain a return on and return of capital.
For a hotel property, proponents of this approach would deduct the manage-
ment fee and franchise fee (if it is a branded hotel affiliated with a chain) along with
other operating expenses. By removing management fees and franchise fees from the
revenue, appraisers reason that the influence of intangible assets has been eliminated.
This approach maintains that the offices, staff, salaries, and overhead associated with
management of the hotel reside not with the owner of the real property but with the
company that manages and operates the hotel for the owner of the real property.
Advocates of this approach state that because the management fee compensates the
management company for those expenses, including staffing the hotel, the value of
any intangible assets is removed, and any remaining net income is attributable to the
real property. Advocates further state that, in the case of branded hotels, removal of
the franchise fee eliminates intangible assets attributable to the brand and the final re-
sult represents only the value of the real property and the tangible personal property.
The management fee method is also sometimes used by appraisers to account
for intangible assets inherent in other property types that typically have a business
management fee or franchise. Proponents of this approach say it is justified on the
same grounds as the market participant survey-based approach described below in
situations where market participants rely solely on the deduction of management
fees to account for intangible assets. A different view is that removal of the cost of an
asset or service does not remove all value associated with the existence of that asset
or service. For example, opponents of this method suggest that paying the utility bills
on a property does not remove the value associated with having the property served
by electricity, gas, water, and sewer service.
Market Participant Survey Approach

Interviews with market participants and, in some cases, regulatory filings may be
used to assist in understanding the value allocated to intangible assets in market
transactions. For example, in valuing specific property types, appraisers may in-
terview market participants to ascertain how buyers and sellers of those properties
value or allocate intangible assets in pricing decisions. The same questions may also
be posed regarding personal property and how this property is valued or priced. The
objective of that sort of exercise is to determine the thinking of market participants
on these issues as opposed to relying on post-transaction book values recorded by
accountants in financial statements.
Appraisers also research filings with the Securities and Exchange Commission.
Given the dominance of real estate investment trusts (REITs) in various property
classes and the regulatory requirements imposed on publicly traded companies,
these filings may be insightful, if only as a secondary source. According to Account-

ing Standards Codification Topic 805: Business Combinations, companies are re-
quired to allocate the purchase price of an acquired company among the tangible and
intangible assets when acquired. As discussed in Chapter 36, the 2017 update to ASC
Topic 805 redefined a “business” to clarify the conditions under which a transaction
involves a business combination or an asset acquisition, which are treated differently
on balance sheets under generally accepted accounting principles (GAAP).
Sales verifications and market interviews may be used as the foundation for the
treatment of intangible assets. Advocates say that the strength of this approach is that
its conclusions are tied directly to the marketplace. It also recognizes the possibility
that treatment of intangible assets may vary based on property type (e.g., conve-
nience stores, marinas, stadiums, and health care properties) and asset class. Critics
of this approach say that survey responses of buyers and sellers may be influenced
by tax or financial considerations or other nonmarket conditions, which may result in
a skewed survey. Critics also assert that buyers and sellers may have no need or mo-
tivation to allocate the value of traded assets to the various component parts and that
this is not really a method at all but only a part of normal verification requirements of
professional standards for comparable data.
Reconciliation
As with all appraisals, in the reconciliation of the approaches to value, appraisers con-
sider the relative strengths and weaknesses of each of the approaches and arrive at a
final value opinion. Depending on the scope of work, the value opinion for a property
operated as a going concern may require an allocation of the value opinion between
the asset classes. Table 37.6 illustrates how an appraiser might compile the results of
the valuation techniques applied to assist in reconciling those value indications.
In some assignments, the scope of work may include an allocation of value to the
asset classes, but it may not be possible to make the allocation within the approaches
to value. In those cases, it may be appropriate to first reconcile to a final value opin-
ion for the property overall and then estimate the appropriate allocation as part of
the reconciliation process. Two methods commonly used to allocate the value opinion
within the reconciliation are the cost approach and market participant surveys.
Table 37.6 Reconciliation

Real Personal Subtotal Intangible Total Value as a
Property Property Tangible Assets Property Going Concern
Cost approach $2,550,000 $168,000 $2,718,000 — —
Sales comparison approach — — — — $2,950,000
Income capitalization approach $2,421,000 $168,000 $2,589,000 $311,000 $2,900,000
Final value opinion $2,420,000 $170,000 $2,590,000 $310,000 $2,900,000
Note: In this example, the cost approach is used only to value the tangible assets. The income capitalization approach uses the excess earnings
method and therefore provides a value indication for each of the asset classes. The sales comparison approach is used only to value the total
property as a going concern, without allocation. The breakdown of the approaches will vary depending on the assignment and on the information
available. For example, it may be possible in some assignments to derive a value indication for intangible assets by the cost approach. In other
assignments, the income capitalization approach may only provide a value indication for the property as a going concern, without allocation.

Communicating Value Opinions
When talking about properties operated as going concerns, market participants
sometimes use imprecise terms or use terms inconsistently. This can cause confusion
for both the appraiser and the reader of the valuation report unless the appraiser
clearly identifies what is included in the appraisal and what is not. For example, mar-
ket participants might refer to the value of intangible property as business value, busi-
ness enterprise value, goodwill, or blue sky, or sometimes even as the going-concern value.
The total value of all asset classes might be referred to as going-concern value, the value
of the total assets of the business, or sometimes business value or business enterprise value.
Lenders sometimes request an opinion of what they call dark value or value as if dark,
meaning the value as if the business is closed. Going-concern value, business enterprise
value, and dark value are problematic terms in an appraisal setting because they may
be confused with types of value, i.e., alternatives to market value, investment value,
use value, or disposition value.
An appraisal report should include precise language that communicates four things:
1. The type of value being reported (e.g., market value, investment value, use value,
disposition value)
2. The assets or asset classes included in the valuation
3. The valuation premise (i.e., the going-concern premise or the liquidation premise)
4. Property rights appraised
The following are examples of language that adequately communicates the informa-
tion outlined above:
• “Market value of a going concern, including the fee simple interest in real prop-
erty along with tangible and intangible personal property.”
• “Market value of a going concern, including the leasehold interest in real prop-
erty along with tangible and intangible personal property.”
• “Use value of the real property only, as part of the going concern.”
Each of the individual terms may also need to be defined in the report.
A market value opinion should be based on the going-concern premise or the
liquidation premise, whichever is the highest and best use of the assets considered as
a whole (i.e., all categories of assets rather than just real property). A lender or other
client may request a value opinion for real property as if it were not occupied by
the business, which is commensurate with the liquidation premise, even though the
highest and best use is continued operation as a going concern. The actual occupancy
situation and the occupancy premise for the appraisal should be clearly disclosed in
the appraisal report.

Index
above-the-line expense, 437, 445, 462 (fn. 2) sequence of, 365-366

accessibility and site analysis, 183-184 and trend analysis, 374-375
accounting, 652-656 and unit-in-place method, 553-554
accrued depreciation. See depreciation See also cost-related adjustments, in sales
comparison approach; dollar adjustments,
active market, 22, 107, 280 in sales comparison approach; gross
actual age, 562 adjustments; net adjustments; percentage
adjustments, in sales comparison
addenda, in appraisal reports, 625 approach; property adjustments;
additions to capital, as exclusion from quantitative adjustments; transactional
reconstructed operating statements, 456 adjustments
adequacy, and functional utility, 233-234 ad valorem taxes, 55, 92-93, 171
adjustable variable-rate mortgages, 119 advocacy, 647-648
adjusted sale price age. See actual age; effective age
and bracketing, 376-377, 401 age and life relationships, 560-567
and market data grids, 361-363, 399-400, 403 agents of production, 15-16, 18-19
and quantitative adjustments, 371-376 agricultural districts, 158-159
adjusted unit price, 405-406, 409-411 agricultural land, 65, 158-159, 189-191, 337
adjustment grid, 83, 110, 361-363, 399-400, 403 agricultural properties, 158-159, 189-191
adjustments buildings on, 241
and comparative-unit method, 547-551 and soil, 176-178
and cost approach, 568, 574 air-conditioning systems, 223-224
evaluating, 362-366 as variable expense, 451-453
for highest and best use, 387, 394-395 See also heating, ventilation, and air-
and land and site valuation, 339-342 conditioning systems
for property rights, 362-366, 378-380 AI Reports, 607-609
in sales comparison approach, 78, 361-366, air rights, 65-66, 169, 337
375, 378-396
alarm systems, 226 assessment data, 622-623
allocation, and land valuation, 35, 342-343 certification, 32, 615-616
alternative use, scoping, 318-319, 321 comparison of report types, 606-612
Americans with Disabilities Act (ADA), 215, definition of value, 30, 41, 618
217 effective date of value opinions, 618-619
annual debt service, 463-465, 470 executive summary, 615
annualizer, 486 extraordinary assumptions and
annual loan constant. See mortgage constants hypothetical conditions, 43-44, 193-194, 619
annuities, and yield capitalization, 479-481 and Fannie Mae, 85-87, 607-609
annuities payable in advance, 480 final value opinion, 37, 614-615, 624
anticipation, 22 form reports, 85-87, 607-609
and income capitalization approach, 414 general assumptions and limiting
and land valuation, 335 conditions, 619-620
apartment districts. See multifamily highest and best use, 328, 623
residential districts history of property, 620-621
apartments, and sample income and expense identification of subject property, 618
forecasts, 506-508 identification of type of value, 618
appraisal improvements, description of, 622
definition of, 1-3 intended use of, 40-41, 618
discipline of, 15-18 intended users of, 40, 618
foundations of, 15-18 introduction to, 614-617
intended use of, 6-7, 40-41 land description, 621-622
scope of work, 30-32, 75-80 land value, 623
See also consulting; review; valuation letter of transmittal, 614-615
process
location data, 618
appraisal assignments
market analysis, 34, 623
conditions, 30, 42-45
narrative reports, 609, 612-625
types of, 6-7
oral reports, 606
appraisal client, 39-40
outline, 612-613
Appraisal Institute, 1-2, 32, 43, 49, 55-57, 87,
98, 101 presentation of data, 619-623
appraisal problem, 30, 75-77 problem identification, 618-619
definition of value, 30, 39, 44 qualifications of appraiser, 624
determination of scope of work, 30-32 reconciliation of value indications, 624
effective date of value opinion, 30-32, 41 report formats, 606-612
identification of relevant characteristics of restricted reports, 606
property, 30, 32, 41-42 review reports, 628-633, 638-640
limiting conditions, 42-45 scope of work, 79-80, 619
appraisal reports, 37, 605-625 site data, 166, 175, 177, 623
addenda, 625 summary of important conclusions, 615-617
analysis of data and conclusions, 623-624 table of contents, 615
approaches to value, description, 623-624 tax data, 622-623

types of, 606-612 balance, mortgage, 119-120
and Uniform Standards of Professional balance, principle of, 25-28
Appraisal Practice, 605-606 and land valuation, 335-336, 342
appraisal review. See review and sales comparison approach, 352-353
appraisal reviewers. See reviewers balloon mortgage, 118
appraisal theory, 15-18 balloon payments, 482
appraisers band-of-investment techniques, 463-465
and consulting, 645-649 and land and building components, 464-465
and foreign investors, 88-89, 662 and mortgage and equity components,
liability of, 7 463-464
licensing and certification, 2-3 banks. See commercial banks; mutual savings
qualifications of, 2-3 banks; savings and loan associations
and reviewers, 627-644 barns, 242
approaches to value, 36-37, 78 baseboards, 224
See also cost approach; income base lines, 167-168, 176
capitalization approach; sales comparison basements, 199, 214-215, 217-218, 234
approach finishes, 217-218
arbitration, 648 base rent, 420-424
architectural style, 230-232 bathrooms
See also functional utility adequacy of, 233, 235
architecture, 230-232 fixtures, 221-222
definition of, 230 bays, in commercial buildings, 236
and technological developments, 231-232 beams, structural, 204-205, 208, 210, 214-216
See also formal architecture; vernacular below-the-line expense, 437, 445
architecture
benchmark building, 544-549
arm’s-length transaction, 48, 109
benchmarking, 198
asbestos, 207-208, 211
biotechnology parks. See life science and
assemblage, 66, 173-174, 311 biotechnology parks
assessed value, 6-7, 50, 55, 92-93, 171-172, 647 blocks. See lot and block system
assessment data BOMA. See Building Owners and Managers
in appraisal reports, 622-623 Association International
in site description, 171-172 book depreciation, 456, 540
assessment ratio, 55, 93 as exclusion from reconstructed operating
asset classes, 664-666 statements, 456
assignments, of leasehold interests, 62 book value, 7, 540
assumptions, 30, 42-44 boundaries
See also extraordinary assumptions; legal descriptions of, 166-168
general assumptions and limiting of market areas, 138-139, 141-142
conditions; hypothetical conditions; bounds, 166-167
special assumptions
bracketing, 376-377, 401
attached equipment, 227
auditing, 659-662
automated valuation models (AVMs), 268-271
Index 683
breakdown method, of estimating interior supports, 214-217
depreciation, 576-597 interior walls and partitions, 214, 216
building activity, 91-92 miscellaneous equipment, 225, 227
building, and architecture, 230-232 painting and finishing, 217-218
building capitalization rate, 464-469 plumbing systems, 220-222
building codes, 4-5, 27, 92, 113, 144-145, 149, protection against decay and insect
170, 197-198 damage, 219
and highest and best use analysis, 306-309 quality and condition surveys, 244-247
and ordinances, 197-198 roof and drain systems, 208
building components. See building size, 198-199
description
special features, 211, 219-220
building costs, 92, 543-548
stairs, ramps, and elevators, 215
and comparative-unit method, 547-551
storage areas, 214
cost-estimating methods, 543-558
substructure, 200, 204
and entrepreneurial profit, 549
superstructure, 200, 205
included in contractors’ bids, 555-557
use classification, 197
and quantity survey method, 555-557
ventilation, 206-207, 223
sources of, 92, 544-545
windows, storm windows, and screens, 208
and unit-in-place method, 551-554
building envelope, 200
See also cost-estimating services; cost index
trending; direct costs; indirect costs Building Owners and Managers Association
(BOMA) International, 98-99, 199
building description, 193, 248
building residual technique, 466-470
air-conditioning, 223-224
building style and function, 193-194, 230-247
and building codes, 197-198
bundle of rights, 4-5, 59-61
ceilings, 215, 218
Bureau of the Census, data from, 97, 104-105
chimneys, stacks, and vents, 208, 211
See also data collection and analysis
electrical systems, 223-225
Bureau of Economic Analysis, data from, 97
elements of, 196
equipment and mechanical systems, 220-227
Bureau of Labor Statistics, data from, 98, 104
exterior, 200-213
exterior doors, 207, 209
business cycles, 114-116
exterior walls, 207-208
business enterprise value. See business value
facade, 208-209
business value, 663-679
flooring, 215-218
See also fair value; use value
footings, 204
buyers and sellers, 2, 21-25, 48-52, 72, 107,
format, 199-200 112, 114-115
framing, 205-206
heating systems, 222-224 call systems. See communication systems
hot water systems, 222-224 CAM. See common area maintenance
insulation, 205-206 capital
interior, 214-219 additions to, 456
interior doors, 214, 216 as agent of production, 19

sources of, 123-132 in market area analysis, 114-116, 273, 275,
See also capital markets and capital market 278-282, 289-295
instruments; yield rates changing income, and yield capitalization, 489
capital expenditures, 445, 456 chattel fixtures. See trade fixtures
capitalization. See direct capitalization; yield chimneys, 208, 211
capitalization See also fireplaces
capitalization in perpetuity, 483-486 chronological age. See actual age
capitalization rates, 35-36, 136, 427-433, cities, origins and growth patterns, 146
459-474, 475-492
cleaning, as variable expense, 452-454
See also direct capitalization; equity
capitalization rates; going-in capitalization Clean Water Act, 180-181
rates; overall capitalization rates; terminal climate, and agricultural land, 190
capitalization rates
CMOs. See collateralized mortgage obligations
capital markets and capital market
instruments, 112, 116-120 coal heat, 222-223
See also debt capital; deeds of trust; equity coefficient of variation, 264-265
investment; mortgage; stocks cogeneration, 228
capture, forecasting, 290, 297, 303 collateralized mortgage obligations (CMOs),
carpeting. See flooring and floor coverings 131
cash equivalency analysis, in sales columns, 204, 215-216, 236-237
comparison approach, 381-382 commercial banks, 129
cash flow, 125, 135-136, 424-433, 436, 475-492, commercial districts, 149-156
493-504 See also central business districts;
See also discounted cash flow analysis community shopping centers; entertainment
cash flow rate. See equity capitalization rates districts; neighborhood shopping centers;
office districts; regional shopping centers;
cash on cash rate. See equity capitalization rates retail districts; specialty shopping centers;
CBDs. See central business districts super-regional shopping centers
ceilings and ceiling heights, 215, 218 Commercial Green and Energy-Efficient
Addendum, 203, 228
in commercial buildings, 236-239
commercial properties, 236-239
in industrial buildings, 239-241, 583-584,
590-592 common area maintenance (CAM), 73, 437, 441
in residential buildings, 233-235 common level ratio, 93
in special-purpose buildings, 241-243 communication systems, 226
in warehouses, 240-241, 406-411 communications technology, 66, 227, 239
census data. See data collection and analysis community banks, 129-130
central business districts, 154-156 community shopping centers, 151-153, 236-237
central limit theorem, 265-268 comparability of data, 355-358
central tendency, 254-256 comparable properties, 361-362
certification, in appraisal reports, 615-616 comparative analysis, 371-396
chambers of commerce, as source of general See also elements of comparison; paired
data, 98, 142 data analysis, in sales comparison
approach; relative comparison analysis;
change, principle of, 22-23 sales comparison approach
in income capitalization approach, 414 comparative-unit method of cost estimating,
and land valuation, 335-336 547-551
Index 685
Competency Rule, 215, 243, 665 cost approach, 36-37, 525-598
competition, 24 applicability and limitations of, 530-532
competitive supply, 95, 104-107, 278-279 and appraisal principles, 528-530
competitive supply and demand data, 104-107 procedures, 532, 542
competitive supply inventory, 95 cost-benefit studies, 646-647
complementary land uses, 138-140, 147 cost-estimating services, 544-545
complementary properties, 138-139 cost index trending, 545
compound interest, 430, 476, 480 cost-related adjustments, in sales comparison
concessions, 384 approach, 375
concurrent ownership of real property, 68 cost to cure, 244, 561, 572-573, 576-592
condition of improvements. See quality and Council of Economic Advisors, 97
condition survey credit regulation, and Federal Reserve, 121-122
conditions of appraisal, 30, 42-45 crops, 26, 158, 189-191
conditions of sale, in sales comparison curable functional obsolescence, 561, 576,
approach, 382-385 585, 588-589
condominium ownership, 71-72 curve, statistical, 260-265
confidence interval, 266-267, 602-603
conformity, principle of, 26-28, 147 damage. See property damage
conservation easements, 65 data collection and analysis, 32-35, 81-110,
consistent use, 315 249-272
construction. See building activity and appraisal reports, 82-83, 85-87, 96
constructive notice, 169 and online access, 98-100
consulting, 645-649 sampling, 84-85
Consumer Price Index (CPI), 97-98 data levels, 251-252
contamination and disclosure. See data sources, 96-107
environmental liabilities competitive supply and demand data,
continued occupancy clauses, 445 104-107
contract for deed, 120 macro-level data, 87-94, 96-99
contractor’s bid price. See building costs micro-level data, 94-97, 100-107
contract rent, 62-63, 421 data splitting, 745
contribution, principle of, 26-27 data standards, 85-87
and cost approach, 528 See also Uniform Appraisal Dataset
contributory value, 51 data types, 250-252
convertible mortgages, 119 date of value opinion, 30, 41
cooperative ownership, 72 in appraisal reports, 618-619
corner sites, 173 debt capital, 129
corporations, 9, 14, 67-72, 133 See also commercial banks; junior mortgage
originators; life insurance companies;
cost, definition of, 21-22 mutual savings banks; secondary
See also building costs; development cost; mortgage market
direct costs; indirect costs debt coverage ratio (DCR), 465

debt service, 72, 119, 125, 135, 425, 429, 436, patterns, 566-567
457, 463-465, 470-471 and remaining economic life, 565
decline and remaining useful life, 565
in demand, 19, 140-141, 279 reproduction and replacement cost bases,
of market areas, 140-141 539-541
decorating expenses, 450, 453 straight-line, 564-566, 572
decreasing annuities, 480-481 types of, 539-541, 578-581
decreasing returns. See increasing and See also book depreciation
decreasing returns desire, definition of, 20
deeds, 59-74, 199-101, 169-170 deterioration. See physical deterioration
deeds of trust, 117-120 developer’s profit. See entrepreneurial profit
deferred maintenance, 37, 244-246, 572-582 development cost, 21, 24, 530-531, 546
deficiencies, in depreciation analysis, 587-590 for subdivision, 340, 347
requiring addition, 584, 586-587 diminishing returns. See increasing and
requiring substitution or modernization, 584 decreasing returns
deficit rent, 422-423 direct capitalization, 36, 433, 459-474
See also excess rent applicability, 460-461
demand, 21-25, 95-96, 114-116, 140-141 and comparable sales, 460-463
for hotels, 294-295 defined, 459
for housing, 115, 292-295, 301 derivation of rates, 460-466
for industrial properties, 290, 301 formulas, 459-460
inferred and fundamental, 289-304 and gross income and rent multipliers,
for office space, 290, 294, 301 473-474
for proposed property, 291 and land and building band of investment,
464-465
for retail space, 90, 236-239, 290, 299-300
and mortgage and equity band of
See also supply and demand investment, 463-464
demand studies, 31, 95-96, 289-304 and overall capitalization rates, 460-466
demographics, 90-91, 99-101, 141-143 procedure, 460-461
depletion allowances, 456 and replacement allowance, 460-462
depreciation, 17, 23, 26, 34-36, 539-541, 559-598 and residual techniques, 466-473
actual age and effective age, 562 and yield capitalization, 460, 484-485
age and life relationships, 560-567 See also overall capitalization rates
in appraising and accounting, 540 direct costs, 21, 535
and breakdown method, 576-597 direct reduction mortgages, 119
components of, 560 disaggregation, 138
and economic age-life method, 571-575 discounted cash flow (DCF) analysis, 36,
and economic life and useful life, 562-565 493-504
and external obsolescence, 591-597 applicability, 493-495
and functional obsolescence, 583-591 common income and value patterns, 496-502
market extraction method, 568-571 formulas, 499
methods of estimating, 559-598 and highest and best use analysis, 325
Index 687
and investment performance and property values, 143-144
measurement, 495-504 economic life, 244-245, 562-565
office/retail building example, 517-523 See also remaining economic life
shopping center example, 509-511 economic property interest, 62-64
subdivision development example, 512-517 economic syndications. See syndications
and yield capitalization, 494-495, 475-480 economic trends, 88-91, 111-136
discounting, 433, 476-479 See also international economic trends;
discounting models, 483-492 local markets, and economic trends;
discount rates, 120-122, 429 national and regional economic trends
disequilibrium, 279 education districts, 159-160, 163
dispersion, 256-260 effective age, 145, 562
disposition value, 55-57 effective date. See date of value opinion
distribution facilities, 156-157, 240-241 effective demand, 19, 24
districts, 138-139, 142 effective gross income (EGI), 424, 449
characteristics of, 147-164 effective gross income multiplier (EGIM),
361, 473-474
See also agricultural districts; commercial
districts; industrial districts; market effective purchasing power, 20, 137, 147
areas, neighborhoods, and districts; effective rent, 421-422
multifamily residential districts; one-unit efficiency of markets. See real estate markets,
residential districts; specialty districts relative efficiency of markets
dividend. See equity dividend EGIM. See effective gross income multiplier
Dodge Data & Analytics, 544 electrical systems, 223-225
dollar adjustments, in sales comparison electric heating, 222-223
approach, 367
elements of comparison
See also comparative analysis
in lease analysis, 438
dominant tenement, 64-65
in sales comparison approach, 362-365,
doors, 207, 209, 214, 216 377-396
See also exterior doors; overhead doors elevators, 211, 215-216, 225-226
downtowns. See central business districts Ellwood, L. W., 467-468, 494
downzoning, 331 Ellwood Tables, 467-468
drainage, 208, 219 eminent domain, 4-5, 59-60, 65
energy efficiency, 197, 200, 202-203, 206, 212,
easement appurtenant, 64-65 227-228
easements, 11, 64-65, 169 entertainment districts, 156
See also conservation easements entrepreneurial coordination, as agent of
economic age-life method, 571-575 production, 18-19
economic base, 111-113 entrepreneurial incentive, 19, 536-539, 546
economic base analysis, 283-287 entrepreneurial profit, 19, 536-539
economic characteristics, in sales comparison environment
approach, 393-394 and market area analysis, 144-147, 293
economic considerations in site description and analysis, 184-189
in market area analysis, 143-144, 273-307 environmental contamination and risk, 185-189

environmental controls, and agricultural See also operating expenses
resource land, 191 expert testimony, 686-687
environmental forces, and property values, exponential-curve change per period
21-22 annuities, 480-481
environmental liabilities, 308-310 exposure time, 43
environmental regulations, 308-310 exterior description of buildings, 200-213
equilibrium, 115, 279-283 exterior doors, 207, 209
equipment and mechanical systems, 220-227 exterior walls, 207-208
equity capitalization rates, 136, 427-429, externalities, principle of, 28
463-464, 470-471, 503
and cost approach, 529
equity dividend, 125, 425, 429
and sales comparison approach, 353
equity dividend rates. See equity
capitalization rates external obsolescence, 34, 591-597
equity income, 425, 457 extraction, in land valuation, 35, 78, 342
equity interests, 67, 470 extraordinary assumptions, 30, 43-44
and yield capitalization, 427, 477, 482 See also general assumptions and limiting
conditions; special assumptions
equity investment, 67, 117, 125, 130, 135, 429,
448, 463, 503
See also international equity capital; facade, in building description, 208-209
joint ventures; life insurance companies; fair value, 6-7, 51-52, 651-662
partnerships; pension funds; real estate
investment trusts; syndications; trusts accounting, 653-656
equity ratio, 463-464 fall-out demand, 283
equity residual technique, 470 Fannie Mae, 49-50, 85-87, 94, 131, 133, 198,
232
equity yield rate, 134-136, 429, 463-464
Farmer Mac, 131, 133
escalation clauses, 443-444
farms. See agricultural properties
rent from, 443-444
feasibility analysis, and cost approach,
escalators, 215, 226, 237 531-532, 542
escape clauses, 444-445 See also highest and best use
escheat, 4-5 feasibility rent, 542
excess earnings method, 672-675 analysis and highest and best use, 325-326
excess land, 174-175, 328-329, 338-339 feasibility studies, 531-532, 646
See also surplus land Federal Agricultural Mortgage Corporation.
excess rent, 422-423 See Farmer Mac
See also deficit rent Federal Emergency Management Agency
(FEMA), 178-181
exclusive use clauses, in leases, 445-446
federal government. See government;
expenditures made immediately after government regulations
purchase, 385-386
Federal Home Loan Mortgage Corporation
expense and income ratios, 457-458 (FHLMC). See Freddie Mac
expense recovery clauses, 443-444 Federal National Mortgage Association
expenses (FNMA). See Fannie Mae
data on, 95, 108 Federal Open Market Committee (FOMC),
in leases, 440-446 121-122
Index 689
Federal Reserve System, 120-122 foreign investment, 88-89, 128-129, 414
fee simple estate, 60-61 formal architecture, 230
FEMA. See Federal Emergency Management See also vernacular architecture
Agency foundations, 200, 204, 219, 246-247
final reconciliation. See reconciliation of fractional interests. See partial interests
value indications
framing, 205-206
final value opinion, 37, 602-603
Freddie Mac, 49, 86-87, 94, 131-133, 198, 232
Financial Institutions Reform, Recovery and
Enforcement Act (FIRREA) of 1989, 629 frontage, 172-173
financial property interests, 67 fuel oil, 222-223
financial reporting, 651-662 functional inutility, 193-194, 230-244
financing, 6-7, 40-41, 72-74, 117-120 functional obsolescence, 232, 235, 583-591
in sales comparison approach, 380-382 functional utility, 193-194, 230-244, 355-356,
392, 583-591
finishes and finishing, in building
description, 217-218 and buildings on agricultural properties, 241
fireplaces, 208, 217-218, 233 and commercial properties, 236-239
See also chimneys definition of, 232
fire protection equipment, 225-227 and industrial properties, 239-241
FIRREA. See Financial Institutions Reform, and mixed-use buildings, 243-244
Recovery and Enforcement Act of 1989 and residential properties, 233-235
fiscal policy, 28, 121 of site, 172, 230-244
fittings. See plumbing and special-purpose buildings, 241, 243
fixed expenses, 426, 449-450 fundamental demand analysis, 281-283,
See also insurance, and operating expenses; 297-303
taxes; variable expenses future benefits, in income capitalization
fixtures, 5-6, 221-222, 225, 246 approach, 36, 424-426
See also trade fixtures future value, 476-478, 501
flashing, 211, 219, 246
flat rental leases, 419 garbage removal, 450-451
floodplains, 182-185 gas, natural
flooring and floor coverings, 215-218 as heating fuel, 222-223
floors, 220, 223 as variable expense, 450-452
footings, 204 GBA. See gross building area
forecasting demand general assumptions and limiting conditions,
42-44
and hotel properties, 294-295
in appraisal reports, 619-620
and housing, 292-295, 301
general data. See macro-level data
and industrial properties, 290, 301
general partnerships, 69, 126
and office space, 290, 294, 301
Geodetic Survey Program, 176
and retail space, 236-239, 290, 299-300
geographic information system (GIS), 104-106
and vacant land, 303
geological survey map, 176
forecasting, in discounted cash flow analysis,
494-495 Ginnie Mae, 131-133
GLA. See gross leasable area

going-concern value. See business value handicapped access, 215, 217
going-in capitalization rates, 481 hard costs. See direct costs
going-out capitalization rates. See terminal hard money lenders, 130
capitalization rates heating fuels, 222-223
government heating systems, 222-224
four powers of, 4-5 as variable expense, 451-453
and market area analysis, 144-145 heating, ventilation, and air-conditioning
and property values, 87 systems, 224, 229
as source of general data, 32, 91-92, 97, 106 hedge funds, 128
Government National Mortgage Association highest and best use, 34-35, 305-334
(GNMA). See Ginnie Mae in appraisal reports, 328
government regulations, 4-5, 11-13, 24, 45, 91, and cost approach, 313-315, 322, 332, 529
113, 144-145, 197-198, 215
definitions of, 305-307
and land and site valuation, 336-337
and excess and surplus land, 328-329
and real property rights, 60
financially feasible use, 312
See also building codes; zoning
and ideal improvement, 313-315
government securities, 122
intensity of use, 330-331
See also Treasury bills
and interim uses, 311, 313, 330, 333
graduated-payment mortgages, 119
and land residual analysis, 324-325, 343-344
graduated rental leases, 419
and land and site valuation, 338-339
graphic analysis, in sales comparison
approach, 374 of land as though vacant, 307-313
green building, 196-200, 202-203, 212-213 legally nonconforming uses, 330-332
gross adjustments, 367-368 legally permissible use, 306-310
gross building area (GBA), 198-199 and marketability analysis, 305, 310-313,
320-322
gross income. See effective gross income;
potential gross income and market analysis, 320-322
gross income multiplier, and direct maximally productive use, 307, 312
capitalization, 473-474 and mixed uses, 334
gross leasable area (GLA), 199 physically possible use, 305-307, 310-311
gross leases, 418-419, 437 of property as improved, 307-308, 313-315
gross living area (GLA), 198-199 purpose of, 305-307
gross rent multiplier (GRM), 473-474 in the sales comparison approach, 331-332
ground rent capitalization, in land valuation, and special-purpose properties, 334
340, 345-346
and speculative investment, 311, 323
grounds maintenance, as operating expense.
See maintenance and repairs statements in appraisal reports, 328
grouped data analysis, 372-373 and supply and demand, 320, 322
growth, in market life cycle, 140-141 testing of, 305-307, 312-315
guide meridians. See principal meridians timing of use, 305-306, 310-312
gutters and downspouts, 208, 210, 219, 246 and zoning changes, 309
Index 691
high-technology parks, 160-162 and effective gross income, 424, 449
historical age. See actual age forecast, 505-508, 511
historic districts, 163-164 and lease analysis, 482-483
historic preservation easements, 163-164 multiyear income forecast, 506-508
historic properties, 163-164 net operating income, 424-425
historic value. See date of value opinion one-year income forecast, 505-506
hoists, 215-216 and potential gross income, 424, 448
holding period, 135, 478 by property type, 506-508
See also projection period and rent, 441-442
home equity loans, 117-118 vacancy and collection loss in, 448-449
Hoskold premise, 484 income capitalization approach, 36, 413-524
hot air heating systems, 222, 224 and anticipation and change, 414
hotels, 237-239 applicability of, 414-416
hot water heating systems, 222-224 and appraisal principles, 414
household formation, 89-91, 113 and data analysis, 435-458
households, 24, 88-91, 96-99, 113 definitions, 416-431
See also demographics and direct capitalization, 459-474
housing demand, 147-149, 233-235 and discounted cash flow analysis, 493-504
hurdle rate, 496 forecasting income estimates, 436-437, 495,
hydronic systems. See hot water heating 505, 509
systems formulas, 459-460, 464-465, 477, 499, 504
hypothetical conditions, 30, 44, 619, 639-641 future benefits, 424-426
and income rates, 428-429
identification of characteristics of property, and inflation, 431
30, 41-42, 76-77, 165-248 interests to be valued, 415
improvement analysis, 193-248 and investment value, 416
analysis of functional utility, 230-244 and land valuation, 344-349
building description, 193-248 and market value, 416
See also architectural style methods of, 431-433
improvements, description of, in appraisal procedure, 431-433
reports, 622
and rate estimation, 429-431
See also building description; tenant
improvements rates of return, 427-429
income and residual techniques, 466-472
data on, 438-446 and risk, 430-431
forecasting in income capitalization and supply and demand, 414
approach, 436-437, 495, 505, 509 and yield capitalization, 475-492
and reversion, 425-426, 481-483 and yield rates, 427-430
See also effective gross income; net income models, 483-485
operating income; potential gross income
exponential curve (constant ratio), 484-485
income and expense estimates, 435-458, 462
level income, 483-484
developing, 436-437, 446-458, 462
straight-line, 484

variable or irregular, 483 intelligent buildings, 227
income rates, 428-429 intended use of appraisal, 30, 40-41, 76-77, 618
estimating, 429-431 intended users of appraisal, 30, 40, 76-77, 618
See also yield rates interest-only mortgages, 119
income streams, 36 interest rates, 89, 93-94, 97, 117-124
and increasing or decreasing annuities, real vs. nominal, 124
480-481 See also compound interest
level annuities, 480 interim uses, 27, 311, 313, 330, 333
variable annuities, 479 interior decorating, in improvement analysis,
income taxes, as exclusion from 217-218
reconstructed operating statements, 456 interior description of buildings, 214-219
increasing annuities, 480-481 interior doors, 214, 216
increasing and decreasing returns, 27 interior walls, 214, 216
incurable functional obsolescence, 247, 561, internal rate of return (IRR), 496-502
576, 583-584, 589
and DCF analysis, 496-502
incurable physical deterioration, 247, 561,
579-581 definition of, 496
index leases, 419 as investment performance measurement,
496-502
indirect costs, 21, 535
limitations of, 502
industrial
negative, 500
building, sales comparison of, 406-411
and reinvestment, 500-502
districts, 156-158
with a specified borrowing rate, 501
properties, 239-241
international commerce, 88-90, 128-129
space demand, 301
international economic trends, 88-90
inferred demand analysis, 280-283, 291-297
international equity capital, 128-129
inflation, 123-124
international investment, 128-129
and rates of return, 123-124
international valuation, 2
and value, 431
international valuation standards, 2, 48-49,
information technology, applications of, 81 53-54, 86
infrastructure, 19, 159, 238 International Valuation Standards Council,
insect pests 48-49
and control service expense, 454 internet, data sources on, 96-106
in improvement analysis, 219 interquartile range, 259-260
inspection, property, 32, 79, 194-195 interval ownership. See timesharing
installment sale contract. See contract for investment
deed and internal rate of return, 496-502
Institute of Real Estate Management (IREM), and performance measurement, 502-504
457-458
investment analysis, in income capitalization
insulation, 205-206 approach, 493-504
insurable value, 55 example of, 517-523
insurance, and operating expenses, 437-439, investment value, 6, 53-55
447, 449-450
and income capitalization approach, 416
intangible assets, 5-6, 663-679
Index 693
investment yields, 135-136 land capitalization rate, 36, 464-469
Inwood premise, 484 land contract. See contract for deed
IREM. See Institute of Real Estate land description. See land analysis
Management land residual technique, 16, 469-470
IRR. See internal rate of return and highest and best use, 35-36, 312, 324-325
irregular income and land valuation, 340, 343-344
and income models, 483, 490 land-to-building ratios, 174, 183, 240
and property models, 490 land trusts, 14, 68-69
land use, 9-13
joint tenancy, 68 and air rights, 65-66, 169, 337
joint ventures, 127 information in site descriptions, 170-171
judgment samples, 84 restrictions on, 10-13, 336-337, 341
junior liens, 118 land valuation, 335-349
junior mortgage originators, 130 and allocation, 342-343
and appraisal principles, 335-336
kurtosis, 263-264 in appraisal reports, 623
and excess and surplus land, 338-339
labor and highest and best use, 338-339
as agent of production, 16, 18 and income capitalization techniques,
availability of, 147, 151-152, 157-158, 160, 344-349
190-191 and land residual analysis, 343-344
data on, 97-98 and market extraction, 342
land and physical characteristics and site
as agent of production, 18 improvements, 337-338
economic concepts of, 12 and property rights, 336-337
geographic and environmental concepts and proposed subdivision, 346-349
of, 10 and sales comparison, 339-342
legal concepts of, 10-12 techniques of, 339-349
legal description of, 10-12, 165-166, 169 layout, and functional utility, 232-235, 238-239,
physical characteristics of, 172-181 244
social concepts of, 12-13 lease analysis, 440-446
title and record data, 169-172 and cancellation clauses, 440
See also excess land; land valuation; lot and continued occupancy clauses, 445
block system; metes and bounds system; dark store, noncompete, and exclusive use
rectangular survey system; surplus land clauses, 445-446
land analysis, 165-192 and division of expenses, 441-442
corner influence, 173 escalation clauses, 443-444
and environment, 184-191 escape clauses, 444-445
excess and surplus land, 174-175, 328-329 expense recovery clauses, 443-444
plottage or assemblage, 173-174 expense stop and expense cap clauses, 443
and site improvements, 182-183 kick-out clauses, 444-445
size and shape, 172-173 purchase options, 444

renewal options, 443 and property models, 486-487
rent concessions, 441 leverage, 136
tenant improvements, 435-437, 441-445 and equity interests, 136, 429, 500
See also leases; rent liability, of appraisers, 7
leased fee interests, 61-63 life cycles, of real estate markets, 114-116,
definition, 61-63 140-141
valuation of, 415 life estates, 64
leasehold interests, 61-63 life insurance companies, 127-130
definition, 62 life science and biotechnology parks, 162-163
valuation of, 415, 423-427 like-kind exchanges, 383
See also contract rent; market rent; limited liability company (LLC), 70
subleases limited-market property, 25, 219
leases, 61-62, 418-420 limited partnerships, 69, 126-128
and bundle-of-rights theory, 4 limiting conditions, 619-620
data contained in, 60-63, 418-420, 440-446 See also general assumptions and limiting
definition of, 62, 418 conditions
and expenses, 418 linkages, 112, 146-147
renewal options in, 443 liquidation value, 55-57
types of, 60-63, 418-420 listing, 33, 100-103
See also flat rental leases; gross leases; litigation support, 648
index leases; revaluation leases; step-down live-load floor capacity, 236, 240
leases; step-up leases load-bearing walls, 206-208, 214-216
leasing commissions, 437, 455, 530-535, 542, loading facilities, 155, 162, 225-226, 239-240
545, 552
loan constants. See mortgage constants
legal characteristics, in sales comparison
approach, 394-395 loan payments, as exclusion from
reconstructed operating statements, 456
legal descriptions, 42, 100
loan-to-value ratios, 463-465
of land, 166-168
local markets, and economic trends, 88-102
See also lot and block system; metes and
bounds system; rectangular survey system location, 41-42
legal entity ownership, of real property, 68-70 defined, 146-147
legally nonconforming uses, and highest and influence on value, 139, 144-147
best use analysis, 330-332 and property adjustments, 390-392
legal property interests, 64-66 in sales comparison approach, 390-392
lessee, 61-63, 137 long-lived items, 245-247, 580-582
lessor, 61-63, 137 lot and block system, 167-168
letter of transmittal, 614-615 See also parcels, of land
level annuities, 479-480 lot size, adjustment for, 392
See also annuities payable in advance;
ordinary annuities
macro-level data, 87-94, 96-100
level-equivalent income, 485
sources of, 96-100
level income
See also data collection and analysis; micro-
and income models, 483-485 level data
Index 695
maintenance and repairs, as variable and income capitalization approach, 416
expense, 450-455 See also value
management fee Marshall and Swift/CoreLogic, 544, 548-549
method of valuation, 676-677 mean, 260-261
as variable expense, 450-451 mechanical systems, 220-227
market, definition of, 9-10 See also plumbing
marketability analysis, 273-275, 283-285 median, 260
market analysis, 34, 114, 273-304 medical districts, 159-161
applications, 289-304 metes and bounds system, 166-167
in approaches to value, 275-276, 297 mezzanine loan, 119
definition of, 34, 273-275 micro-level data, 94-96, 100-107
and highest and best use, 274-275, 283-284, sources of, 100-107
290-291, 297, 305-306, 311-314
See also macro-level data
inferred and fundamental, 291-303
mineral rights, 11, 191, 336-337
levels of, 280-285, 289-304
miniwarehouses, 240
six-step process, 273-276, 289-291
MISMO, 86
types of, 280-285, 289-304
mixed-use buildings, 243-244
market area delineation, 276, 291-293
mixed-use development (MUD), 243-244
market areas, neighborhoods, and districts,
34, 137-164 mixed uses, and highest and best use
analysis, 334
analysis of, 137-164
mode, 255-256
boundaries of, 141-142, 293-295
modernization. See deficiencies, in
change in, 140-141 depreciation analysis
characteristics of, 138-142 modified gross lease, 418-419
definition of, 138-140 modified internal rate of return, 501
See also districts mold, 207
market conditions, in sales comparison money, 116-132
approach, 387-390
mortgage, 117-120
market data grid, 361-363
annual debt service on, 463-465, 470
for industrial building appraisal, 408
components, 117-120
for office building appraisal, 403
definition of, 118
for residential property appraisal, 399
interests, 117-120
market equilibrium, 279-280, 283, 303
types of, 119
market extraction method
See also adjustable variable-rate mortgages;
of estimating depreciation, 568-571 junior liens; variable-rate mortgages
and land valuation, 342 mortgage capitalization rate, 136, 463-470
market rent, 62, 420-421, 436-438 mortgage constants, 463
market segmentation, 138, 276, 283-286 mortgage-equity analysis, 67, 463-464
market value, 6-7 changing-income applications, 463-464
definitions of, 47-52 equity yield, solving for, 463
versus fair value, 652 formulas, 463-464

rate analysis, 463-464 functional obsolescence; incurable
rate extraction, 463-464 functional obsolescence
mortgage interests, 67 offering, 6-7, 102-103
mortgage residual technique, 470-471 office buildings, 199, 236-238
move-up demand, 277 and multiyear income forecast sample,
517-523
multifamily residential districts, 149
relative comparison analysis of, 405-406
multiple listing services, 102, 105
rental worksheet, 442
mutual savings banks, 130
sales comparison of, 401-406
office districts, 150-151
narrative appraisal reports. See appraisal
reports office parks, 150-151
National Association of Home Builders, 99 office space demand, 236-238, 290, 294, 301
National Association of Realtors, 98, 102 off-site improvements, 165, 182-183
statistics, 253 one-unit residential demand, 291, 301
National Register of Historic Places, 160, 163 one-unit residential districts, 147-149
national and regional economic trends, 111-136 on-site improvements, 165, 182-183
National Vital Statistics System, 97 operating expense ratios, 457-458
natural gas, 222-223 operating expenses, 108, 426-427, 449-457
neighborhoods, 137-140 exclusions from, 456
See also market areas, neighborhoods, and sample history, 446-447
districts See also fixed expenses; variable expenses
neighborhood shopping centers, 152-153 opportunity cost, 22, 429-430
net adjustments, 367-368 opportunity zones, 127
net leases, 417-418, 437 oral reports. See appraisal reports
net operating income, 424-425, 457 ordinary annuities, 480
and income estimates, 424-425 changing in constant amounts, 484 (fn 5)
net present value (NPV), 496-502 OSCRE International, 86
net proceeds of resale. See reversion overage rent, 88, 423-424
newspapers, as sources of data, 103, 109 overall capitalization rates, 136, 427-429, 432-
NOI. See net operating income 433, 460-466, 490-491
nominal interest rate, 124 band of investment—land and building
components, 464-465
noncompete clauses, in leases 445-446
band of investment—mortgage and equity
nonconforming uses, 170-171, 330-332 components, 463-464
non-realty components of value, 220, 663-679 from comparable sales, 460-462
in sales comparison approach, 395-396 conditions for use, 433
See also intangible assets; personal property and debt coverage formula, 465
normality, statistical, 263-266 formula, 465
normal curve, 123, 260-261 and going-in capitalization rates, 481
from surveys, 465-466
obsolescence, 23, 232, 235, 583-597 overall yield rate, 136, 429, 489-490
See also curable functional obsolescence; overhead doors, 240
depreciation; external obsolescence;
Index 697
overimprovements, 529-531, 535 plottage, 173-174, 383
ownership potential, 173-174
entities, 13-14 value, 66
information, 169-170 plumbing, 220-222
in severalty, 68 POB. See point of beginning, in metes and
See also fee simple estate; partial interests; bounds land description
property interests, types of point of beginning, in metes and bounds
land description, 166
painting, 217-218 point estimate, 30, 602-603
paired data analysis, in sales comparison police power, 4-5, 13
approach, 372-373 pollution. See environmental liabilities
parameter, statistical, 258 pollution rights, 184-185
parcels, of land, 4, 9-12, 20-27, 66-67, 165-168, population, statistical, 252-254
172-176 possession, 61
parking, as variable expense, 450, 453-454 post and beam framing, 205
parsing income method, 675-676 potential gross income (PGI), 424, 448
partial interests, 60-71 definition of, 424
identification of, 60-71 potential gross income multiplier (PGIM),
participation mortgages, 119 433, 436, 474
partnerships, 9, 69-70, 126-127 powers of government, 4-5, 10-12, 144-145
See also general partnerships; limited preliminary analysis, 77
partnerships present value factors, 475, 484, 522
payback period, 503-504 present value of level annuities, 479-481
payroll, as variable expense, 450-452 price, vs. cost, 21-22
pension funds, 127-128 pricing and rent projection studies, 647
percentage adjustments, in sales comparison primary data, 87, 92, 109-110, 194
approach, 367, 388
prime rates, 122
percentage leases, 88, 420
principal meridians, 167-168, 176
percentage rent, 423
private equity, 113
periodic payment, mortgage, 119
product disaggregation, 138
personal interviews, 42, 104, 108-109, 142,
171-174, 188, 377, 677-678 production, agents of, 15-19
personal property, 5-6, 55, 66, 69, 73, 220, 384, productivity analysis, 292-293, 297-299
396, 663-679 profitability index (PI), 504
PGIM. See potential gross income multiplier and highest and best use, 326
physical characteristics progression, principle of, 27
of land, 10, 172-191, 337-338 projection period, 478
in sales comparison approach, 392-393 property adjustments, 364-366, 390-396
physical deterioration, 34, 578-582 property damage, 7, 55, 206, 219, 245-246, 582
physical property interests, 66-67 property description, 32-33
pipes and piping, 210-211, 221-226 property inspection, 32, 79, 194-195
plots, 166 See also site visit

property interests, types of, 61-67 quantitative adjustments, 371-376
See also air rights; easements; economic quantitative analysis, 362, 371-376
property interests; fee simple estate; See also graphic analysis, in sales
financial property interest; leased fee comparison approach; paired data
interests; leasehold interests; legal property analysis, in sales comparison approach
interests; life estates; partial interests;
physical property interests; subsurface quantity survey method, 555-557
rights; transferable development rights
(TDRs); vertical interests
ramps, in public buildings, 215-217, 225-226
property models, 485-492
random samples, 85, 256, 266
exponential-curve changes, 489-490
range
formula, 485-486
statistical, 259-266
level-equivalent income, 490-492
of value, 37, 602
level income, 486-487
ranking analysis, 377
straight-line changes, 487-489
rate extraction
variable or irregular changes, 490
and yield capitalization, 479, 493-495
property productivity analysis, 292-293,
297-299 rates. See discount rates; income rates;
interest rates; rates of return; yield rates
property rights. See real property rights
rates of return, 427-429
property rights adjustment, 378-380, 407,
541-542 estimating, 429-431
property taxes, 92-93, 144-145, 163-164, 437, return of capital, 428
440, 449-450, 544-545 return on capital, 428
consulting on, 647 raw land, 165-166
as operating expense, 437, 449-450 real estate
proposed improvements, and cost estimates, cycles, 114-116, 140-141, 280
543-544 definition of, 3-4
prospective value. See date of value opinion See also real estate markets
public controls. See government regulations real estate investment trusts (REITs), 69,
public debt, 121 125-126, 131-132
public interest value, 54 real estate markets, 112-116, 137-147
public records, as source of microlevel data, characteristics of, 137-142
101 cycles, 114-116, 140-141
public utilities, 64-66, 145-147 relative efficiency of, 114
purchase options, in leases, 444 value influences in, 142-147
real estate mortgage investment conduit
quadrangles, in US Geological Survey, 176 (REMIC), 131
qualifications of appraiser, 2-3, 624 real estate operating companies (REOCs), 69
qualitative analysis, 362, 376-377 Real Estate Standards Organization (RESO),
See also ranking analysis; relative 103
comparison analysis; trend analysis, in real estate taxes. See ad valorem taxes;
sales comparison approach property taxes
qualitative data vs. quantitative data, 250-251 Real Estate Transaction Standard (RETS), 103
quality and condition survey, 244-247 real interest rate, 124
Index 699
real property remaining economic life, 244-245, 565
definition of, 3-4 remaining useful life, 208, 565
and economic forces, 111-113 REMIC. See real estate mortgage investment
and environmental forces, 111-113 conduit
equity interests in, 67 renewal options in leases, 443
and government forces, 111-113 rent
identification of, 3-4 analysis of, 441-442
mortgage interests in, 67, 117-120 types of, 420-424
ownership, 13-14, 67-74 rent concessions, 441
and social forces, 111-113 rent projection studies, 647
real property rights rent-up adjustments, in cost approach, 541-542
in cost approach, 541-542 repairs. See maintenance and repairs, as
variable expense
and income capitalization approach, 415,
438, 460-462 replacement allowance, 426-427, 454-456
in sales comparison approach, 378-380 as variable expense, 426-427
See also fee simple estate; leased fee interests; replacement costs, 533-534, 539-541
leasehold interests; partial interests reports. See appraisal reports
recapture rate, 7, 486-488 reproduction costs, 533-534, 539-541
recession, 115, 123, 129, 423 (fn 4) resale, proceeds of, 493, 509-510, 517-523
reconciliation of value indications, 37, 599-603 research and development parks, 157, 159-162
in appraisal reports, 624 Residential Green and Energy Efficient
definition of, 599 Addendum, 200, 202-203, 228
and final value opinion, 602-603 residential properties, 147-150, 233-235
questions asked, 601 ownership benefits, 19-20
in sales comparison approach, 366-369 sales comparison of, 397-401
reconstructed operating statement, 83, 446-458 residual capitalization rates. See terminal
capitalization rates
apartment building example, 507
residual demand analysis, 296-297, 301-303
exclusions from, 456
residual techniques
rectangular survey system, 167-168
and direct capitalization, 466-472
refuse and refuse collection. See garbage
removal and highest and best use analysis, 35-36,
312, 324-325
regional shopping centers, 151-154
See also building residual technique;
See also super-regional shopping centers equity residual technique; land residual
regression analysis, 249, 268-269 technique; mortgage residual technique
multiple regression, 249, 270 retail districts, 149-156
simple linear regression, 249, 268 retail properties, 149-156, 236-239
See also statistics retail space demand, 91, 149-156, 236-239,
290, 299-300
regression, principle of, 27
retrospective value. See date of value opinion
reinvestment concepts, 500-502
return of capital, 428
REITs. See real estate investment trusts
return on capital, 124, 428
relative comparison analysis, 376-377
revaluation leases, 420

reverse annuity mortgage (RAM), 119 office building example, 401-406
reversion, 425-426, 481-483 paired data analysis, 371-373
and yield capitalization, 475-477, 481-483 procedures, 355-369
review, 3, 627-643 qualitative analysis, 362, 376-377
development of review opinion, 634-638 quantitative adjustments, 371-376
form, 631, 634, 638 reconciliation in, 366-369
for litigation, 628-629 residential property example, 397-401
problems in, 640 and required data, 355-358
purpose of, 629 sample size, 252-257, 265-268
reporting review options, 638-639 sampling, 265-268
role of reviewer, 628-630 See also data collection and analysis
scope of work, 630-634 sandwich interests, 62-63
standards for, 631 savings and loan associations, 130
structuring of assignments, 631-634 scarcity, definition of, 20
who can prepare, 629-630 scenario analysis, 374
workfile, 639-640 scope of work, 75-80
See also reviewers in appraisal reports, 79-80, 619
reviewers, 3, 627-643 screens, window, 208-209, 246
See also review secondary data analysis, 87, 109-110, 142
review reports. See appraisal reports secondary mortgage market, 129, 131, 133
revitalization, 140-141 See also junior liens
right of first refusal, 444 securities. See government securities; stocks
rights of way, 5, 169 securitization, 131-132
risk, 134-135 security systems, as variable expense, 450,
and income capitalization approach, 430-431 452-454
roofs, 208 segregated cost method. See unit-in-place
method of cost estimating
rounding, of value opinions, 602-603
sensitivity analysis, 372
rural land trends, 89-90, 337
sequence of adjustments, 365-366
R values, 211
servient tenement, 65
sewers, as variable expense, 450, 452
safe rate, 430
share-accounting rate. See time-weighted rate
sales comparison approach, 36, 351-412
shared appreciation mortgages, 119
and adjustments, 361-366, 375, 378-396
shopping centers, 149-156, 236-239
applicability of, 353-355
See also regional shopping centers; super-
and appraisal principles, 352-353 regional shopping centers
and comparative analysis, 371-396 short-lived items, 245-246, 579-582
and data analysis, 372-373 Sick Building Syndrome, 207
industrial building example, 406-411 signal systems, 225-226
in land valuation, 339-342 single-family properties. See residential
limitations of, 353-355 properties
market data grid, 361-363, 399-400, 403
Index 701
single-family residential districts. See one- specific data. See micro-level data
unit residential districts speculative investments, and highest and
sinking fund factors, 463, 486-487 best use analysis, 311, 323
definition of, 166 sprinklers. See fire protection equipment
improvements on, 165, 182-183 stability, 15-17
improvements to, 165, 182-183, 336-339 stabilization, 79
vs. land, 166-167, 335 and cost approach, 530
site accessibility, 183-184 stabilized occupancy, 79
site description and analysis. See land stacks, 208, 211
analysis stairs, 215
site improvements, contributory value of, standard deviation, 262-264
165, 182-183, 342-343
Standards of Professional Appraisal Practice,
site valuation. See land valuation 195, 215, 243
site visit, 194-195 statistical analysis, in sales comparison
siting, 146 approach, 373-374
situs, 291 statistics, 249-272
six functions of one, 477 (fn 2) applications, 269-271
skewness, 260-263 central tendency, 254-256
smart buildings, 227 defined, 250-251
snow removal, as operating expense, 453 descriptive vs. inferential, 250-251
social considerations dispersion, 256-260
and market area analysis, 12-13, 112-113, 143 parametric vs. nonparametric, 259
and property values, 21-22, 112-113, 143 regression analysis, 268-269
soft costs. See indirect costs steam heating systems, 205, 226
software, 86-87, 96, 100, 105 step-down annuities, 480-481
cost-estimating services, 544-545 step-down leases, 419
spreadsheets, 262, 269 step-up annuities, 480-481
statistical, 259-260, 262-263, 269 step-up leases, 419
soils and subsoils, 158-159, 176-178, 189-190 stigma, 184
soil survey map, 190 stock corporations, 69-70
space, division of, 214 stock exchanges, 114-115
special assumptions, 43-44 stocks, 112, 117, 121, 126-127, 134
special corporation costs, as exclusions from storage areas, 214
reconstructed operating statements, 456 See also miniwarehouses; warehouses
special-purpose properties, 241-243 storm windows, 208-209
functional utility of, 241-243 straight-line change
and highest and best use analysis, 334 in income models, 484
specialty districts, 159-160 per period annuities, 481
See also education districts; high- in property models, 487-489
technology parks; historic districts; life
science and biotechnology parks; medical straight-line depreciation, 564-566, 572
districts; research and development parks subdivision development analysis
specialty shopping centers, 152-156 discounted cash flow example, 512-517

in land valuation, 346-349 See also ad valorem taxes; income taxes, as
subflooring, 215 exclusion from reconstructed operating
statements; property taxes
subject capture analysis, 297, 303
tax parcels, 92
subleasehold interests, 61-63
Tax Reform Act of 1986, 28, 88-89
subleases, 61-63
tax shelters, 70, 89, 126-127
submarket, 137-138, 142
T-bills. See Treasury bills
subprime loans, 131-132
TDRs. See transferable development rights
substitute properties, 25, 138-139
telecommunications, 100
substitution, principle of, 23-25
tenancy, 68
in common, 68
and land valuation, 335-336
by the entirety, 68
and sales comparison approach, 352
See also joint tenancy
substructure, 200, 204
tenant improvements (TIs), 421-422, 437,
subsurface rights, 66, 169, 178, 191 441-445
superadequacies, 583-586, 590-592 tenement, 65
super-regional shopping centers, 149-153 terminal capitalization rates, 417, 481-482,
superstructure, 200, 205 510-511, 521
supplies, as variable expense, 450-454 TIGER. See Topographically Integrated
Geographic Encoding and Referencing
supply and demand, 21, 23-25, 111-115, datafiles
275-276, 279-280, 289-290
TIs. See tenant improvements
timesharing, 72-74
data sources, 104-107
time value of money, 430
definition of, 23-25
time-weighted rate, 504
and highest and best use analysis, 320, 322
title and record data, 169-171
and income capitalization approach, 414
title in fee. See fee simple estate
and land valuation, 335, 347-349
Topographically Integrated Geographic
and sales comparison approach, 352 Encoding and Referencing (TIGER)
See also demand studies datafiles, 104-106
surplus land, 174-175, 328-329, 338-339 topography, in site description and analysis,
surplus productivity, 26-27 175-181
surveys total depreciation. See depreciation
and capitalization rates, 465-466 trade area, 149-154
of market participants, 677-678 trade associations, as source of data, 96
syndications, 70 trade fixtures, 201
See also fixtures
taxes traffic, 112, 145-146, 149-155, 173, 183-185
and consulting, 647 traffic volume data, 183
and corporations, 133 tranches, 131
definition of, 4-5 transactional adjustments, 378-390
and land use information, 171-172, 182, 191 transferable development rights (TDRs),
65-66
in market areas, 113-115
Index 703
transition, evidence of, 115 See also highest and best use
transportation systems, 91, 98, 113 utilities
and market area analysis, 113, 141-142, and site description and analysis, 181-182
145-146, 277, 301 as variable expense, 450-451
Treasury bills, 121 See also public utilities
Treasury Department, 121 utility, definition of, 19-20
Treasury notes, 124, 126 See also functional utility
trend analysis, in sales comparison
approach, 374-375
vacancy and collection loss, 448-449
See also economic trends
vacant land, 34-35, 144, 148-150, 165-166, 174,
trusses, 205, 220 183, 281-282, 300-303, 307-313, 320-333,
trusts, 68-69, 125-128 338-340, 342-348
See also real estate investment trusts See also highest and best use
(REITs) valuation for financial reporting (VFR), 40,
tunnel rights. See subsurface rights 53-54, 651-662
See also fair value
underimprovements, 529 valuation process, 29-38
See also deficiencies, in depreciation value
analysis definitions of, 21-22, 41, 47-57
Uniform Appraisal Dataset (UAD), 85-87, factors of, 19-20
608-609
See also assessed value; business value; fair
Uniform Appraisal Standards for Federal value; final value opinion; insurable value;
Land Acquisitions (UASFLA), 50 investment value; market value; public
Uniform Mortgage-Backed Security (UMBS), interest value; use value
94 value influences
Uniform Residential Appraisal Report in market areas, 142-147
(URAR) form, 82, 607-609
in real estate districts, 147-164
Uniform Standards of Professional Appraisal
Practice (USPAP), 43-44, 49, 84, 270 value theory, 12, 16-18
and appraisal review, 627-631, 639-641 value in use, 53-54
and appraiser liability, 2 vandalism, 582
and definition of market value, 49 variable annuities, 479-480
unit costs, 547-555 variable expenses, 426, 450-454
unit-in-place method of cost estimating, variable income
551-554 and income models, 483
unit-method rate. See time-weighted rate and property models, 490
units of comparison, 359-361, 368-369 variable-rate mortgages, 118-119
URAR. See Uniform Residential Appraisal variable rental leases, 419
Report (URAR) form
variance, statistical, 256-258
urban growth patterns, 146, 284-285, 290,
298-299 ventilation systems, 206-207, 223
useful life, 562-565 See also heating, ventilation, and air-
conditioning systems
See also remaining useful life
vents, 208, 211
use value, 6, 52-54
venture capital. See equity investment

verification of data, 109 Yellow Book. See Uniform Appraisal
vernacular architecture, 230-231 Standards for Federal Land Acquisitions
See also formal architecture yield analysis. See internal rate of return (IRR)
vertical interests, 66 yield capitalization, 36, 433, 475-492
See also air rights; subsurface rights and annuities, 479-481
Veterans Administration, and home applicability and limitations, 475-476,
mortgages, 118, 133 493-495
vital statistics, sources of, 97, 104 discounted cash flow analysis, 493-495
See also micro-level data discounting, 476-479
formula, 477
walls, 207-208, 214-216 income models, 483-485
See also exterior walls; interior walls; load- and income stream patterns, 479-481
bearing walls procedure, 475-476
warehouses property models, 485-492
cost estimate example, 549-551 rate extraction, 493-495
functional utility of, 239-241 reversion, 481-483
sales comparison application example, yield rates, 36, 123-124, 134-136, 478-479,
406-411 495-496
See also miniwarehouses estimation for discounting, 478-479, 495
water, as variable expense, 450-452 extracting from a comparable sale, 511
water rights, 158, 169, 190, 337 See also equity yield rate; income rates
web, data sources on. See internet, data
sources on zero-coupon mortgages, 119
weighted average, 463 zoning
wetlands, 178-181 changes, 170-171, 309
whole building approach, 229 and comparative analysis, 339, 341, 394-395
windows, 208 and highest and best use, 308-310
wiring, 223-227 and land and site descriptions, 170-171
wood, decay and insect damage, 219 and land valuation, 341, 348
workfile, 606-607, 628, 639-640 in market areas, 144-145
work letters. See building costs in real estate districts, 147-164
wraparound mortgages, 119 in sales comparison, 363-365

Index 705

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The Appraisal

Appraisal Institute • 200 W. Madison • Suite 1500 • Chicago, IL 60606 • www.appraisalinstitute.org

PART I Real Estate and Its Appraisal

PART II Identification of the Problem

PART III Scope of Work Determination

PART V Data Analysis

PART VI Land Value Opinion

Part VII Application of the Approaches to Value

vi The Appraisal of Real Estate

PART IX Report of Defined Value

PART X Appraisal Practice Specialties

Table of Contents vii

Jefferson L. Sherman, MAI, AI-GRS

x The Appraisal of Real Estate

2 The Appraisal of Real Estate

What Is Real Property?

The Bundle of Rights

Public Restrictions on Ownership

4 The Appraisal of Real Estate

Why Appraisals Are Needed

4. See Chapter 14 for more discussion of automated valuation models.

6 The Appraisal of Real Estate

Geographic and Environmental

10 The Appraisal of Real Estate

Land, Real Estate, and Ownership of Real Property 11

12 The Appraisal of Real Estate

Public and Private Forms of Real Property Ownership

Land, Real Estate, and Ownership of Real Property 13

14 The Appraisal of Real Estate

The History of Value Theory

The Classical School

Challenges to Classical Value Theory

The Neoclassical Synthesis

16 The Appraisal of Real Estate

Modern Appraisal Theory

The Nature of Value 17

18 The Appraisal of Real Estate

The Nature of Value 19

Effective Purchasing Power

20 The Appraisal of Real Estate

Distinctions Among Price, Cost, and Value

The Nature of Value 21

Anticipation and Change

22 The Appraisal of Real Estate

Supply and Demand, Substitution, Balance, and Externalities

Supply and Demand

The Nature of Value 23

24 The Appraisal of Real Estate

The Nature of Value 25

26 The Appraisal of Real Estate

5. Interim uses are discussed in more detail in Chapters 17 and 18.

The Nature of Value 27

28 The Appraisal of Real Estate

The valuation process is a systematic procedure an appraiser follows to provide

Identification of the Appraisal Problem

Scope of Work Determination

30 The Appraisal of Real Estate

Identification of the Problem

Scope of Work Determination

Data Collection and Property Description

Market Area Data Subject Property Data Comparable Property Data

Market Analysis Highest and Best Use Analysis

Land Value Opinion

Application of the Approaches to Value